Category Archives: Fixed Income

Fixed Income related Post

The Local Bond Market and the Interest Rate Game

percent blocks

The fact that interest rates are at an all-time low, especially in the short history of the local bond market, is known to all investors. Given such a scenario, the following question are interesting to consider:

  • Are all investors factoring in the possibility that interest rates could go up?
  • Are they factoring in the situation that they could be stuck with a lower yield than what they could get on the market once interest rates did in fact go up?
  • Are they appreciating the fact that if interest rates go up the companies borrowing at the low rates might not afford to refinance their bonds at a higher rate?
  • Are the low interest rates and such high demand for any return attracting the wrong bond issuers?

The post will expand on the above questions and other related issues focusing around the local bond market, low interest rates and the high demand for interest paying investments.

The Local Government Bond Market

Following the latest movement of falling interest rates that begun in the aftermath of the 2007-09 financial crisis we have seen the local government issue bonds that are longer dated and have lower interest rates than ever before. These two factors increase the interest rate risk of holding such bonds. But with not many alternatives around the demand for Malta Government Stocks (MGSs) has been consistently strong.

Looking at the yield to maturity (YTM) on the MGSs one would see that it is less than 1% for all bonds with a maturity until 2028. Furthermore, the YTM on the MGSs beyond 2028 goes up to a maximum of just 1.88% which is for a bond maturing in 2041[1]. What this effectively means is that the Maltese government can borrow for a period of over 25 years at a cost of less than 1.9%. The major risk here is that within a period of 25 years a lot can happen, including an increase in interest rates.

Let us take a scenario where interest rates went up by 2% in 10 years’ time and use the 2.40% MGS 2041 as an example. So in 10 years’ time the maturity of the bond would be 15 years away. The current YTM on a 15 year MGS is around 1.15% when the base rate (as determined by the European Central Bank and upon which all other interest rates are calculated) is 0%. So if the base rate had to go up to 2% in 10 years’ time we can assume that the YTM on a 15 year MGS should be around 3.15% (i.e. 2% higher). For the 2.4% MGS 2041 to be yielding round 3.15% in 10 years’ time its price has to go down to around €91 per 100, which is almost 18% lower than the current price.

Of course the above is just assuming that interest rates go up by 2% in 10 years’ time, this could be argued to be a conservative approach. So what would the situation be if interest rates went up by 2% in 5 years’ time instead of 10 years’ time? The price of the 2.4% MGS 2041 would go down to around €80 per 100, representing a fall of around 27% from the current price.

Bond YTM

The Local Corporate Bond Market

Corporate bonds are bonds issued by companies, so on the local bond market it includes any bond that is not an MGS basically. In this area we have also seen a predicted move toward issues of lower interest coupons and the maturities have more or less been at a standard of 10 years. It is much less easy to compare different corporate bonds than it is to compare different MGSs. This is so since different entities will have different risk factors, while MGSs are all issued by the same government of Malta.

So not every issuer is as safe as the rest, for example an issuer who has just one project in Libya is considered much riskier than an issuer that has a diversified portfolio of assets that generate income streams from different markets. The problem is made much worse when interest rates are so low that many issuers are attracted to the market and demand is so high for any interest yield that almost every issue gets over-subscribed.

Such a scenario could create a very devastating outcome when all issuers are able to borrow at below risk-adjusted rates in the current market. The risk here is that if interest rates had to go up by the time such issues mature the company might not be able to re-finance its bond at a rate its cash flows could afford. So for example, we have the upcoming Premier Capital bond maturing which will be rolled over. In the company announcement it was stated that €24.6mln of the old bond will be exchanged for €65mln of a new bond. Assuming the usual 10 year bond maturity is chosen and considering the YTM on the currently existing corporate bonds, it is not difficult to assume that the coupon interest rate on the new bond will be below 4%. One can argue that since the coupon is so much lower the company can afford to actually borrow more (the old bond had an interest rate of 6.8%). This is all well and good, but €65mln is considerably more than €24mln so the interest expense will definitely be higher.

The point I am trying to make is the potential problem that could exist in 10 years’ time when this new bond matures. What would happen if interest rates had to go back up to what they were 10 years ago when the initial bond was issued – would the company afford to refinance such a large amount of borrowing at a higher interest rate? Would investors panic if interest rates go up by 2% in 5 years’ time and the price of the bond would fall to the lower €90s per 100?

I have used the Premier Capital bond just as an example since it is the latest issue to be coming to the market. This is not the riskiest bond issue on the market which actually makes the whole situation worse. In reality there are many other bonds that could suffer the same fate if interest rates had to go up. So what could result would be a simultaneous fall in price of local bonds. Imagine a situation of many bonds on the market falling towards the mid to lower €90s per 100 meaning that investors would be down say 7-10% from the current prices of their bonds. Would we have a situation of a rush to sell such bonds? Considering the fact that such bonds could get very illiquid very fast the prices could go well below the theoretical prices I am assuming here. To make matters worse funds and other investment vehicles that invest into the local bond market which may hold large amounts of the issued bonds could be making the whole situation even worse. If faced with a lot of redemptions at once due to the potential quick fall in the price of these funds an even worse fire-sale situation could ensue.

The Bottom Line

In conclusion it must be stated that the above is all based on assumptions that interest rates go up within the medium to long term. This can very well be the case, but we could also have a prolonged period of low interest rates. In reality it is anyone’s guess and no economic model can accurately predict the reality we will experience. The key to lower one’s risk is to stick to the safer bonds with the shortest maturities and to diversify the portfolio as much as possible. Such a scenario is not favourable to the buy-and-hold investor who would buy a bond with the intention of holding it until maturity. Thus it would make sense to take profits when prices have risen to a decent amount and crystallise such profits by actually selling the position. By doing so and reinvesting into new issues on a regular basis an investor could lower the risks I have focused on here, but they would not be eliminating them. As usual, please refer to a professional investment advisor before taking any investment decision and the usual risk warning applies that nothing presented here is actually investment advice.

 

[1] Figures are as at 21st October 2016

Are Secured Bonds Safe?!

secured-or-unsecured-loans

On the local market we are increasingly seeing bonds being issued secured or guaranteed. In simple terms this means that the issuer has earmarked specific assets to act as collateral just in case the issuer defaults on the Bond. This is similar to the special hypothec that a bank will demand on a property (and/or other assets) when you take out a home loan. On the other hand, when we have a bond issue that has a Guarantor it normally means that a company separate from the issuer is guaranteeing to take on the debt should the issuer default. These features make such bonds more appealing to the retail market, are regarded as safer and hence may be easier to get regulatory approval for and may mean that the issuer can issue the bond at a lower coupon (interest rate) on the back of lower perceived risk. However, are all such bonds really safer?!

Although the features in themselves would make a bond issue safer than if the issue did not include the feature, one must bear in mind to consider the whole picture. Especially when comparing a bond by one issuer to another issuer. The best way to demonstrate what I mean here is to consider some real life bond issues.

A Comparison between a Secured and an Unsecured Bond

So let us consider the 3.50% BOV 2030 bond and the 4% MIDI Plc 2026 bond.

Starting with the BOV issue, being issued by a bank in order to raise its tier 2 capital the bond was issued subordinated, unsecured and including the bail-in clause. What this means is:

  • Subordinated: if BOV had to default on the bond payments the bond holders would be ranked lower than the senior debt of the bank (such as loans from other banks)
  • Unsecured: there are no specific assets acting as collateral exclusively for the bond issue
  • Bail-in clause – subject to certain conditions, should the company be in difficulty and risking a default the bonds may be converted to share and/or subject to a hair-cut (reduced in nominal value).

While the MIDI bond issue was secured by the following assets:

  • Immovable property of the Issuer comprising commercial premises (€25.5 million), car parking spaces (€19.7 million), storage rooms (€1.9 million) and properties earmarked for development (€0.6 million).
  • Pledge of 11,699,999 shares in T14 Investments Limited (C 63982), having a value of €11.7 million.

I must point out the analysis is going to focus mainly on default risk, i.e. the risk of the issuer defaulting on the bond. In order to truly appreciate all the risks with these two bond issues in question one needs to consider other risks as well such as liquidity, maturity and interest rate risk. The aim is to compare the default risk between secured and un-secured bonds of two different issuers.

The importance of considering Probability

An important factor when analysing risk is probability. In simple terms risk is all about 2 factors:

  1. the probability of an event occurring – in our analysis here the event would be a default or near default.
  2. the consequences if such an event actually occurs.

So taking BOV vs MIDI as issuers, the higher risk of default lies with MIDI. This is apparent from the balance sheets and reserves of the two companies. Furthermore, BOV operates in a highly regulated market characterised by constant supervision by local as well as foreign supervisors. MIDI operates in the real estate industry which is illiquid by its very nature. Furthermore, most of the assets owned by MIDI are concentrated in one limited area (Tigne Point), while BOV has a network of properties and a diversified portfolio to assets spread cross different industries and geographical regions. So when it comes to point 1 – the probability of the default or near default occurring is higher for MIDI than for BOV.

Now let us consider the consequences if the event had to occur and BOV was close to default. The whole idea behind the bail-in clause is so that the tax payers would not have to take on the expense of bailing out the bank like what happened in other countries during the financial crisis of 2007-09. What this means for bond holders is that they are taking on more risk and responsibility by buying into these bonds. What results should be more supervision by the bond holders themselves since they now have more at stake should the financial position of the bank deteriorate and this is something known to the management of the bank. So in a way it could act as a safety measure in the sense that the management now is subject to wider scrutiny and hence has to act more vigilantly.

If we assume that the bank comes to the point where it has to enforce the bail-in clause and converts some of the bonds into shares this would be done at a very low share and thus the bondholders would lose out quite a bit. However, there is an important factor to consider here – the loss would be an un-realised or paper loss and not a realised one. This means that should the bond holders hold on to those shares and the bail-in actually works the value of the shares would be expected to recover over the years. One must keep in mind that a bank such as BOV is a very systematic company meaning that if it had to default the repercussions on the whole economy would be tremendous and much larger than if MIDI had to default. Thus, every measure possible would be used in order to save the bank.

If we take MIDI on the other hand one might consider that the bond holders are safe since if the company had to default the assets used as security would make up for any loss in value. Unfortunately things are not that simple. If the company had to default it would mean that it did not sell and/or rent enough of its properties. This means that if it had to default the value of such properties (the security) would go down and we would have a situation where a supply side shock could be created where a significant amount of properties concentrated in the same small area would be put up for sale. Thus, considering the fire-sale prices that would exist in such a situation the security making good for the €50mln of issued bonds could very well be lower in value. Another thing to consider with the securitisation of assets is that other lenders would know about this special hypothec and thus would consider themselves in a high risk situation. So if the company needed to borrow more money in the future it would surely be more expensive for it to do so. This is an important point when considering the fact that it intends to eventually develop the Manoel Island properties.

The Bottom Line

In conclusion, it must be pointed out that the risk of default of either of the issues mentioned above is not considered to be high. I took extreme situations in order to demonstrate what would be expected if such events occurred and the secured vs unsecured attributes were tested. The point should be clear that just because a bond is secured it does not mean that it is less risky than another unsecured bond.

The fact of the matter is that the riskier issuers are the ones which in fact need to issue secured bonds in order attract more and/or cheaper finance.

I would also like to highlight once more that the analysis was simply on the default risk and other risks need to be considered before investing into these or any other investments.

KD

MIDI Plc vs IHI Plc – a Bond Comparison

MIDIvsIHI

This past week we have seen the announcement of two new bonds with similar features being issued by two different companies, namely MIDI Plc and International Hotel Investments (IHI) Plc. Both bonds will have a 4% coupon and will mature in 10 years’ time. Furthermore, both are secured, meaning both issuers have safeguarded specific assets that will be tied to the issue of the bonds.

Instead of going through the salient features in great detail I thought it would be more interesting to offer a comparison of one bond against the other. This should help investor to decide which one to opt for if they intend to invest into them.

 

4% MIDI Plc 2026

4% IHI 2026

Principal Activity “development and disposal of immovable property situated in Malta at Tigné Point, Sliema and Manoel Island, Limits of Gzira. MIDI operates principally in the high-end segment of the property market in Malta.

“In June 2000, the Company acquired land comprising Tigné Point and Manoel Island from the GOM by title of temporary emphyteusis for a period of 99 years as from 15 June 2000. Construction works commenced in late 2000. Under the same Emphyteutical Deed, the Issuer also acquired from the Malta Maritime Authority, for a period of 99 years, the right to develop and operate a yacht marina on a defined area facing the south shore of Manoel Island in Ta’Xbiex Creek, Limits of Gzira”

“ownership, development and operation of hotels and ancillary real estate in Europe and North Africa.

To date, IHI has acquired and/or developed hotels in Prague (Czech Republic), Tripoli (Libya), Lisbon (Portugal), Budapest (Hungary), St Petersburg (Russia) and St Julian’s (Malta). NLI is a joint venture between IHI and LFICO, each party holding 50% of the issued share capital in NLI. NLI owns the 294 roomed luxury hotel and residential development in London (UK)”

Security Various properties owned by the Company plus shares in T14 Investments Ltd The Hungarian company IHI Magyarország Zrt is listed as a Guarantor.
Major Risk Factors The bond is backed by what the Company owns and the Company depends on the selling of high end properties and the leasing of commercial spaces. So if the high end market had to take a hit not only would the Company be in trouble, but even the security of the bond would lose value! The Company is suffering losses from its ownership of the hotel in Libya and the hotel in St. Petersburg due to the ongoing turmoil and political unrest plus weak currencies in these countries. This is being compensated by the positive results in the other countries, yet still in 2015 the company registered a loss. The highest risk going forward is the major project that the Company is considering for the St. George’s Bay area. So tourism and real estate are the areas that will determine the success going forward.
Risk-Reward Ratio Not worthwhile. The risk involved in definitely not worth the reward of a fixed 4% for 10 years. Having said that, the 4% level is in line with what the secondary market bonds are going for so the Company is right to issue such a low interest rate Same as for MIDI.
Reason for the Issue To pay off the maturing bonds worth around €40.8mln, paying off other obligations and general maintenance and restoration work To pay off obligations of the group in respect of outstanding debt and acquisition costs, plus a maximum of €10mln on professional fees for the St George’s Bay Development.
Chances of Allotment Quite Low unless you hold the old bonds – with €40.8mln replacing existing bonds which one would expect an acceptance level of 80-90% and €2mln earmarked for the shareholders of the Company there is not expected to be much left for the general public. Medium – One would expect high demand for the bonds given the lack of available options. €30mln is earmarked for shareholders, even if this is fully taken up by existing shareholders there are still €25mln left for the general public.
Treatment of Existing Bondholders Unfair. Part of the existing bonds being replaced are denominated in GBP. The conversion rate for the GBP bonds (since the new ones will be issued solely in EUR) was established after the Brexit at €1:£0.834, so the GBP bondholders got a rotten deal on the exchange. On top of that existing holders who used to earn 7% will not be earning 7% until December which is the actual maturity date of the existing bonds. If existing bond holders invest into the new bond they will start earning 4% from when it is issued and forgo the difference in rates until December. Much Better! In the past whenever IHI or Corinthia have rolled over existing bonds they always paid the full interest until the maturity date of the bond, even when they rolled over for a lower amount. In such cases the company would have paid the difference in the two rates so that the investor is not left worse off for investing into the company again.
Would I Buy and Hold? NO. At 4% fixed for 10 years and given the risk involved I would not expect this to be a great addition to a portfolio to keep until maturity. To keep short term and earn the 4% interest until something better comes alone, ok. But if the price goes up enough, I would definitely sell out and take the profits. Same as for MIDI.
Expected Demand High. The fact of the matter is that there are not many alternatives and investors have accepted a higher risk tolerance for lower returns (even if they have not realised it yet). Same as for MIDI.

 

The Bottom Line

Comparing the two issues one has to keep in mind that with neither is one getting a good deal here. Having said that they are offering what one could find on the market with other existing bonds which are yielding between 3.5%-4% for similar risk bonds. When deciding between the two one has to keep in mind the chances of being allotted a decent amount for the amount applied. My notes in the above table should be kept in mind, the clear winner would be the IHI bond on this point.

A worrying point in my opinion is the treatment given to these issued by the listing authority which actually shapes the terms and conditions under which the bonds may be sold. Towards the end of 2015 and beginning of this year we had the complex BOV bond issues which were very restricted in to whom they could be sold. A few months ago we had the GlobalCapital roll over which was also very restrictive in o whom it could be sold. Now we have these two issues which are open to anyone. This begs the questions:

  • Is MIDI really that much safer than GlobalCapital?
  • Are MIDI or IHI safer than BOV as an issuer? – definitely not!
  • Is the security being put forward that safe?
  • How will the assets of both MIDI and IHI be affected by the Brexit and the concerns in the EU?
  • How big of a concern is the exposure to Libya for IHI – both directly and through its strategic partners the Libyan Foreign Investment Company (LAFICO) and its ownership though MIH Plc?

As usual, before investing into any of the mentioned financial instruments please consult the prospectuses and a good financial adviser. Kindly note the usual general disclaimer that applies to all my publications.

KD

Retirement Planning – a Portfolio Approach

saving_and_retirement

Retirement Planning – a Portfolio Approach

I would like to start this post by pointing out a very important fact: Planning for retirement does not mean buying an investment called “Pension Fund” or “Retirement Fund”. Many seem to think that in order to plan for their retirement they need to buy an investment that somehow has “retirement plan” of “pension plan” in its name. This is definitely not the case. In order to plan for one’s retirement one must think of all their assets as forming part of one overall portfolio.

The principal aim of retirement planning is to have a decent income once one retires from their employment and for estate planning. It is no secret that the state aid will not be enough for many people to earn an income in retirement that is compatible with the standard of living that they would have become accustomed to during their working life. Thus, it is important to plan in order to earn supplementary income. Does this mean that everyone should start buying income paying products from a young age – NO!

The best way to plan for retirement planning is for one to structure his/her assets in an overall portfolio structure. As with any portfolio investment one needs to plan according to one’s:

  • investment objective,
  • risk tolerance
  • financial affordability
  • knowledge and experience.

It must also be kept in mind that all the above points will evolve over time and are not static. Thus your retirement portfolio must also evolve to reflect these changes.

Investment Objective

For someone who is in their initial years of their working life their investment object is going to be quite different than for one who is close to the final years of their working life. Furthermore, it is not only an age thing, but other factors also have an effect on the investment objective. An initial objective of any investor would be protection. So a wise choice would be to acquire some form of life insurance and if affordable some form of disability insurance.

Let us assume we have an investor who has purchased their first home, has some form of insurance in place and a decent cash balance for regular expense items. Such a person would have a long term investment horizon and their investment objective would normally be to increase their overall capital. Thus, such an investor would be better off investing in products that focus on capital growth rather than income. The growth in capital possible through equity investing rather than investing in bonds is exponential. Therefore, it would not be wise to invest totally into income paying bonds when one has 30 odd years left until retirement.

On the other hand, someone who is nearing their retirement age should start shifting their portfolio more towards income paying investments. For such a person it would be more important to have something extra coming in rather than possibly doubling their capital in 10 years’ time. So the investment objective is going to have an effect on what investments one should have in their overall portfolio. Moreover, although income is important and normally is the main concern of many investors, if one would also like to leave something extra for their heirs then they should also consider this in their overall portfolio.

Risk Tolerance

This is something very specific to the investor. As a general rule most people are risk averse, meaning that they would rather avoid rather than increase risk. However there is the risk reward trade-off to consider which basically means that the lower the risk the lower the potential return. In general, one who is still a number of years away from retirement would tend to be more able to take on risk for the potential of higher returns compared to someone who is closer to retirement. Even psychologically, investors would be more willing to take on risk when they are younger than when they are older. However, every investor is different in the degree of risk that they are comfortable in taking on. This will affect the type of individual investments that one would put into their overall portfolio. So although a younger person might want to invest in equities to increase their capital in the long term they can buy conservative equities/equity like investments such as an ETF that tracks the overall market, or they could buy a more speculative product that for example moves 3 times the price of oil.

Financial Affordability

Like with anything else in life we should only buy investments that we can afford. The affordability factor should be considered in two main ways. The first is that certain products have a high initial cost. So for example, certain bonds trade in multiples of €100,000 meaning that one needs to buy a minimum of €100,000 in order to buy the bond. The second factor connected to affordability is the percentage of the overall portfolio that the investment will make up. What I am referring to here is the fact that although the investor might afford to buy the asset, he/she would be left too exposed to the one asset if they do in fact invest in it.

An easy way to see how this second factor could be detrimental to a portfolio is to consider investing into property. With interest rates very low and the local rental market doing well we are seeing many people investing into property with a buy-to-let setup. Let us take a hypothetical situation where we have an investor who owns their main residence which is worth around €250,000 at current market rates, has a portfolio of €50,000 in investments, has €10,000 in the bank and is now considering buying an apartment costing say €100,000 in order to rent it out. Without going into the debt factor that this will have, let us assume that the €10,000 will remain on his bank account to cater for unforeseen expenses and act as a buffer. The €50,000 will all be used to purchase the property and the balance will be borrowed from the bank. If this is the case, the assets that make up this persons’ overall portfolio would be €350,000 in property and €10,000 in cash. This would mean that over 97% of this person’s portfolio would be invested into two properties, less than 3% would be in liquid, easily accessible cash and no other investments. Through such an example it is easy to see the concentration risk of going down such a route.

Knowledge & Experience

Another important factor to consider when deciding on which assets to put into one’s overall portfolio is to invest in assets which they are familiar with. This does not mean that one should invest only in things which they have already invested into and not consider anything else. However, one should research investments which they are considering investing into before they actually financially commit themselves. There are many good investment advisors around that can help here, but supplementary research is always a plus. By searching a bit online one will find many avenues where good information can be attained on the assets they are considering investing into. So just like one would consult websites such as booking.com and trip advisor when booking a hotel, investors should also do some supplementary reading before investing their money.

Piggybank and calculator. Isolated on white background
Attaining a Decent Income after Retirement

For many the main goal when it comes to their retirement planning is to secure a decent return after they stop or reduce their main work activity. In my view this is best attained by slowly building a portfolio of diversified assets over the years. The accumulation of income paying products should evolve over time and one is not expected to invest all their money in capital growth products and switch all their money into income paying products on the day they retire. The ideal situation would be to have income coming from different sources so if one of the sources is negatively affected in some way one would have alternatives that they could depend on. So by having some income coming from rental income, some coming from direct bonds and bond funds and some coming from income paying equities one would have different streams of income which are affected by different things.

As one is building their portfolio over the years they should not forget to think of alternative investments to the regular bonds, shares and property mix. Such alternatives would include investing into commodities such as precious metals and oil, investing into art and collectables and also investing into private businesses. A good source where one could attain a good capital appreciation and even income through dividends is by investing into private companies. Many start-ups end up needing additional finance while many other well established businesses also would need extra financing for new projects or to get through a rough patch. It is true that the risk could be lager here than investing into regulated and quoted companies, but if one does their research well and finds a good opportunity they can attain an equity stake in a good company at a decent price which would pay-off in the future. Such an investment could offer good income opportunities and a good asset for the heirs of the person who would eventually take over these shares.

The Bottom Line

The main message I would like to convey through this post is that there is no fixed formula to use when it comes to retirement planning. Everyone has to assess their own characteristics and find the best mix of products that suits them. So called retirement plans are a good start but they are not an end in themselves. Some of these retirement plans do give you a tax break if you use them, but the amount of tax saved per year on them is ridiculously low to have any significant weight.

KD 

BOV Fails to Fully Subscribe its Subordinated Notes – No Surprise!

Back in October 2015 Bank of Valletta Plc (“BOV”) had obtained approval from the listing authority to raise up to €150mln (or its currency equivalent) from a debt issuance programme. BOV has until October 2016 to raise this money based on the current approval and be the end of last year it had already raised half the amount (€75mln) through the first issue of 3.50% Subordinate Notes maturing in 2030. This month however, BOV attempted to raise a further €50mln of the same bonds and only managed to raise €35.59mln, representing a take up of around 73%. Should we be surprised by the fact that Malta’s largest bank has failed to fully subscribe its bond issue – not really!

BOV

I would like to start by referring to a previous post that I published back in November 2015 when BOV had issued the first lot of these bonds. In this post I had explained how EU banks where being forced to add a bail-in clause to any debt that they would like to issue if they would like such debt to be considered as part of their Tier 2 Capital. What this means is that if there is a situation where BOV is facing financial difficulties and requires a bail-in these bonds can be either written down or converted into common equity (shares). The idea was created in light of the difficulties faced by banks in the 2007/08 crisis which had to be bailed-out by the tax payer. We have already seen the mechanism of a bail-in work with the case of Cyprus a few years ago and it was not pretty.

Why the issue was not fully subscribed

It is important to point out that the failure to fully subscribe the issue is not due to the default risk of BOV. When we talk about risk we must keep in mind that there are many different types of risks and default risk (the risk that an issuer defaults on its obligation to pay back the bond) is only one type of risk. To understand why this issue failed we must discuss a bit further the issue itself to understand better the real risks involved which were mainly relating to liquidity, maturity and interest rate risk.

In my previous post relating to these notes I had explained how the bond was issued in two tranches and I had gone into detail about the features of the two tranches. In a nut shell, since these notes have this bail-in clause they are classified as complex products. As a result, the listing authority had imposed on BOV that certain measures be taken to safeguard investors, more specifically to safeguard the smaller retail investors. The restrictions were that Tranche 1 could only be sold with a minimum of 25,000 nominal and had to be accompanied by an appropriateness test while Tranche 2 had to be sold with a minimum of 5,000 and had to be sold following a full suitability test. This created a situation where investment service providers wishing to sell these notes were being asked to take on a considerable amount of responsibility for selling this bond – some may argue that the listing authority was being overly cautious.

  • Liquidity Risk

One of the first issues with these restrictions was the liquidity restrictions that were created. What I am referring to here is the ability to sell or buy these bonds on the market after they are issued. In normal cases it would not be difficult to sell an amount of 25,000 bonds on the market, but in reality when you sell on the market it is normally the case that the 25,000 you would have sold would have been bought in an amount of smaller lots. So for example investor 1 bought 5,000, investors 2 bought 10,000, investor 3 bought 2,500, and so on. Since Tranche 1 of these notes have to be traded with minimum of 25,000 this has severely restricted the chance of trading them on the market.

With respect to Tranche 2 the minimum is more manageable, but they come with a lot of onus on investment service providers whereby essentially these notes need to be sold ‘with advice’. This means that the investment service provider is advising the client to buy a long dated (15 year) bond that is fixed at 3.50% and which they know would be difficult to sell out of. Furthermore, the regulator had contacted the investment service providers specifically on the issue of these notes to warn them about the responsibilities that they would be taking on if they sold these notes.

Thus, as a result of the illiquidity of the issue, after the first batch of €75mln were issued they actually went down in value below the €100 mark they were issued at with barely any trading taking place. This applied for both tranches

  • Maturity and Interest Rate Risk

These two risks are interrelated and I will be discussing them concurrently. Due to the fact that the notes have a life of around 15 years this creates a maturity risk since they are long dated. This, coupled with the liquidity risk explained above means that investors may well be stuck with these bonds until maturity and they would not be able to sell them off easily before maturity. Now let us consider the 3.50% interest rate. Given the current interest rate scenario and comparable bonds on the international markets one may argue that the 3.50% is competitive with other similar fixed income investments. This, in my opinion, is a naïve perspective since this bond has to be compared with an illiquid fixed income investment maturing in 2030 and not with an international bond that can easily be traded!

Therefore, when you consider all the above risks and feature of these bonds it is not surprising that BOV failed to raise the full amount they issued in this second round. As I had stated when they issued their first batch – 3.50% is not worth the risks involved with this issue! The bank tried to take advantage of the low interest rate scenario and tie in investors until 2030 at a low interest rate and it did not work.

interest-rates-going-up

What Now?

So now we are in a situation where BOV has raised around €111.6mln form its total of €150mln, meaning that it has €38.4mln left to raise by October of this year. Technically they do not need to issue any more notes since the €150mln was a maximum amount they could issue, so they could discontinue the €150mln programme. But this still leaves a shortfall since the bank, like all the other banks, is continuously subject to tighter capital controls and thus still needs to continue raising more capital. Furthermore, BOV has bonds maturing in next 4 years, which across 4 issues total to €215.4mln.

In a statement made to the Times of Malta the Bank’s management has said that it will explore the possibility of selling the bond to institutional investors abroad – it will be interesting to see if they keep the terms the same for these institution investors. Will the bank be approaching fund managers or other regulated entities such as other banks and insurance companies? This would be a tricky thing for these entities since we are talking about an illiquid, unrated, subordinated bond issued by a Maltese bank and subject a bail-in clause.

So what other options could BOV consider for future capital raising?

·         Issuing more notes – increasing the coupon

Let us consider the option that BOV decides to go ahead and attempt to keep issuing more subordinated notes with similar features. If BOV decides to increase the interest rate and issue new note at a higher interest rate than the ones it issued so far from this program it will have a worsening effect on the price of the current bonds in issue. BOV might reach its goal of raising the remaining €38.4mln, but it would have left holders of €111.6mln of its notes worse off for a long time.

·         Issuing more notes – changing the maturity

BOV could issue more notes with a different maturity in order to make them more attractive. But it must be pointed out that these are subordinated bonds and in order for such notes to be fully considered as part of the capital of the bank they have to be long dated obligations. So issuing say a 5 year note would not really help the bank to meet its capital requirements as much as a 10 or 15 year note would.

·         Making a rights issue

Another way to raise capital is for the bank to issue more shares through a rights issue. A rights issue is basically an offer to existing shareholders to buy more shares in the company. A firm will normally initially opt for a rights issue as opposed to an issue to the general public in order to allow existing shareholders not to be diluted. Remember that when new shares are introduced these shares will end up with a percentage of the ownership of the company. So if existing shareholder do not buy new shares the percentage of the total ownership of their holding will be reduced.

The largest shareholder of BOV is actually the Government of Malta with just over 25%. Therefore, if the government does not have the finances to invest more money into BOV and also does not want to lose its percentage of ownership it would be against a rights issue. So although this might sound like a good solution, it may not even be on the table if the government (as the controlling shareholder) does not allow it.

Did over-regulation play a part?

Another issue that led to the failure of this issue was what I have been referring to in many previous posts – that over regulation (for example the imposition of a high minimum or the imposition of carrying out a suitability test) will end up marginalising the small retail investors rather than help them. The pressure put by the regulator on local investment service providers that were considering selling these notes was high. It was a kin to asking the companies selling the notes to guarantee the issue since if something had to go wrong with the investment such companies would be heavily scrutinised. This pressure, coupled with the upcoming Arbiter for Financial Services Act that I reviewed in my previous post made little business sense for the investment service providers to sell this issue.

The Bottom Line

Although riskier bonds have been issued by other companies that were fully or over-subscribed these cannot be really compared to this issue. The reason this issue was not a success was not due to the default risk of the bank, but due to other factors particular to the issue itself. It will be interesting to see how it all develops and I am sure a solution will be found. Let us hope that it is the best decision for all investors and no political influence will come into play.

KD

 

 

BOV Issues a Convertible Bond

BOV

It has just been announced that Malta’s largest bank, Bank of Valletta Plc (BOV), will be issuing a subordinated 15 year bond with a coupon rate of 3.50%. What is most interesting about this issue is the fact that the bonds being issued are gong to be convertible bonds. This means that in the case that the Bank is facing financial difficulties and requires a bail-in these bonds can be either written down or converted into common equity (shares).

Capital Adequacy

BOV like all other EU banks is facing much tighter capital requirements. Following on from the 2007/09 Financial Crisis the EU Regulators have become much more strict on the amount of capital that banks should hold. Thus, Banks are required to hold higher levels of capital in comparison to the assets that they hold.

In accounting we learn that

Assets = Liabilities + Capital

This means that any asset that a business owns is financed either by the capital that the owners put into the business, or through borrowings of some sort. The bigger the capital base, the more the shareholder or owners of the business have at stake if the assets of the business had to deteriorate in value. Thus, the bigger the capital base the more money the owners would have at risk. Hence, one would expect owners (shareholders) to be more cautious in their approach when they have a business in which they have invested a large amount of capital, as opposed to one with minimal capital invested.  Capital also acts as a buffer and so the larger the capital pot, the larger the buffer in the case of a deterioration in asset value.

Based on this simple idea, the European Central Bank (ECB), as the regulator of all major EU banks, has been pushing the banks it regulates to hold more capital. When it comes to financial institutions the riskiness of the assets held by the business is a major factor affecting the calculation of how much capital is adequate for such entity to hold. In a nutshell, the riskier the assets the higher the level of capital required to be set aside.    

The below video explains capital adequacy through good simple examples:

 Why a Convertible Bond?

Convertible subordinated bonds are considered as part of a bank’s Tier 2 capital. This means that it is counted as part of the required capital that BOV must have in place to cove its risk-weighted assets. Keep in mind that the local market is predominantly interested in interest paying assets and that interest rates have been very low for quite a while now. As a result, BOV, like all the other banks, has experienced an increased in deposits. Deposits for a bank are a liability since it is money owed to clients.

As a result, when deposit are increasing at such a high rate the ratio of assets financed by liabilities (deposits) will increase compared to the ratio of assets financed by capital. Thus the capital ratios of the bank will start going down and more capital is needed to act as a buffer.

Besides this €150 mln debt issuing program (€75mln of which will be issued in the coming days) that will see the bank increase its Tier 2 capital, BOV had also mentioned plans to increase its Tier 1 capital. This will be achieved by a new equity injection which most likely would be in the form of a rights issue. A rights issue is a new issue of shares that is made available to the existing shareholders. The shareholders would then have the option of either buying up the new shares and investing more money into the bank, or else they can simply sell the right to buy the new shares.

Banking & Finance

Is the Interest of 3.50% Adequate?… Not Really!

All the above is evidence that BOV needs to increase its capital reserves and the main reason for issuing this convertible bond is in fact to meet capital requirements. In their latest financial results which were published just a few weeks ago BOV also noted a deterioration in the assets they hold. This was a direct result of last year’s  Asset Quality Review and the stress tests carried out by the European Central Bank. These exercises highlighted that BOV had higher specific risks which have resulted in an overall impairment charge of €32.7 mln, a significant increase of €13.3 mln over the impairments recognized in the previous financial year.

The facts described in the above paragraph, coupled with the facts that this is a 15 year (i.e. long term) bond being issued in a scenario of historically low interest rates, and on top of all this it is ultimately a convertible bond, make the 3.50% annual return too low versus the risks involved. Keep in mind the inverse relationship between interest rates and bond prices. Although interest rates are not expected to be increased in the short term, there is a good chance that they will go up in the medium to long term. When they do, this bond will be one of the worst hit domestically issued corporate bonds given its long term maturity. Thus, the bond presents a high level of interest rate risk (please click here to view a previous post that discusses this in more depth).

Besides a significant interest rate risk the bonds also present  liquidity risk. The local market is limited in its size and many investors tend to buy and hold. Thus it may be difficult for an investor to sell off these bonds once they start trading on the market if such investor wanted to sell before the maturity date.  If this bond was a regular bond (i.e. not a convertible bond) this risk would be quite low, at least in the short term. However, given the fact that this bond is in fact a riskier type of bond which in legal financial jargon is referred to as a complex product, BOV has had to issue it in two separate tranches. This fact has made the bonds subject to higher liquidity risk,as I explain below

The bond is being issued in the following two tranches:

  1. Tranche 1 – Subject to a minimum 25,000 nominal holding throughout the life of the bond
  2. Tranche 2 – Subject to a minimum of 5,000 nominal

Here’s the complication. In order to protect the retail investors the Regulator has forced BOV to issue the bond in the above tranches which are subject to certain compliance requirements from the point of view of the financial intermediaries which will be selling the bond.

In order for a financial intermediary to be able to sell the first tranche (subject to minimum of 25,000) the intermediary must prepare what is known as an appropriateness test. This test basically checks the knowledge and experience of the applicant to see if the product is “appropriate” for the client based on his past experience, his qualifications and his field of employment. Should the intermediary determine that the applicant does not posses the required knowledge and experience, the transaction can still be completed, however the intermediary needs to inform the client about this (this is normally done in the form of a risk warning which the client signs). If the client buys this tranche he/she must always maintain a minimum of 25,000 bonds.

In order to sell the second tranche (subject to the lower minimum of 5,000) the clients need to pass a suitability test. This suitability test is used when a financial intermediary is advising the client directly to buy the product (or when adding the product to the client’s discretionary portfolio). A suitability test, besides checking the knowledge and experience like the appropriateness test does, also includes checking the financial bare ability of the client (i.e. if the client can afford the investment) and also the investment objectives of the client (risk tolerance and investment objectives). Thus, in order for this second tranche to be sold the intermediary needs to be advising the client to buy this bond issue. This puts a lot of responsibility on the intermediary and cannot be done if the client fails any part of the suitability test. Moreover, I am not sure why an intermediary would recommend a long term convertible bond with such a low interest rate.

Given the restriction imposed on holders of tranche 1 bonds, it will be harder to sell off these bonds since batches of 25,000 would most likely have to be sold at one go. Moreover, if many applicants opt for these tranche 1 bonds they might not be even allocated any bonds. The issue is subject to a maximum of €75 mln. Thus, if many applicants apply for these tranche 1 bonds , even if they were all allocated the minimum of €25,000 they might still in total add up to more than €75 mln. In such a case BOV stated that it would have to draw lots and allocate 25,000 to some applicants and 0 to others.

Interest-Rate-Uncertainty

The Bottom Line

Given all the above I still think that the issue will be sold and that the €75 mln will be collected. The fact is that there are not that many attractive interest paying investment available given the low interest rate scenario. When faced with such a situation investors would tend to take on more risk and accept less favourable terms. There could still be an opportunity to buy the bonds and sell them for a quick profit in the short term, however this opportunity has been restricted by the liquidity issues mentioned above. Hence, I am not a big fan of this issue and consider the return being offered as too low for the risks being faced when holding such bonds.

As always please refer to the disclaimer – this is simply my personal view and nothing should be taken as advice. I am not a legal expert and clients need to view any investment from their own personal perspective – the aid of a financial intermediary is always preferred.

KD

Malta Government Stock – Should I Buy the New Issue?

flag

On Friday 25th September the government of Malta published on the Government Gazette the issuance of new Malta Government Stock (MGS)MGSs as they are frequently referred to in technical jargon, are bonds issued by the government in order to finance its budget deficit. In essence, the government will have income from taxes and other sources, expenses from the supply of public goods (such as street lighting, road works, general government services…) and when the expenses are bigger than the income the government will issue bonds to make up the difference. Thus through MGSs the government would be borrowing money from investors to finance its operations.

The Offer

The latest offer made by the government is for the following 2 options:

  • 2.00% MGS 2020
  • 2.30% MGS 2029

The Amount

The amount to be issued is €120mln, with the option of issuing a further €60mln (which most likely be the case).

The Interest

The fixed interest is payable every 6 months on fixed dates – for the 2% MGS 2020 this would be 26th March and 26th September each year, while for the 2.30% MGS 2029 it would be 24th January and 24th July each year. Thus the first interest payment would be a pro-rata payment starting from October 12th until the first respective interest payment date of each bond.

The Offer Period

Applications are already available from authorised financial intermediaries, even though the actual offering period starts on Monday 5th October. The offer is scheduled to close on Wednesday 7th October, however the Accountant General always reserves the right to close the offer before if there is a high demand (and this could well be the case).

The Price

As is customary with every MGS issue, the issue price of the new MGSs will be announced just a few days before the offer period starts, in this case the announcement will be made on Thursday 1st October in the afternoon. What is this issue price? The issue price is the price at which the bonds will made available for sale to the public. Thus, although the bonds will mature at a price of €100 per 100 bonds at the end of their respective term, they will not necessarily be issued at a price of €100 per 100 shares. The government most likely will add on a premium over and above the €100 maturity price, which will effectively lower the yield to maturity of the bonds (click here for more about yield).

What are the estimated prices then? Both these MGSs are already trading on the market since they had already been previously issued in the past. Thus if we simply check out the price at which they have been trading lately we can get a better idea of where the new prices might be establish. It is interesting to note that the Central Bank of Malta (CBM) issues on a daily basis what are known as secondary market bid-prices. In effect this means that the CBM is always ready to buy any MGS trading on the market, at the established daily price which it publishes every day (normally between 10-11am). You can access the link to these prices here.

If we focus on the two MGSs at hand, we can see that as at Friday 25th September the latest price for the two MGSs were as follows:

  • 2.00% MGS 2020 – €106.16
  • 2.30% MGS 2029 – €102.56

What does this all mean? This means that as at Friday 25th September (roughly a week before the actual price will be issued) the CBM is willing to buy back these two MGSs at the quoted prices of €106.16 and €102.56 per 100 bonds, respectively. One might ask, why is the bond with the lower interest commanding a higher price than the one with the high interest rate? This is directly related to the maturity risk of the second MGS. Since the second MGS matures in 2029 (c. in 14 years time) as opposed to the first one that matures in 2020 (c. in 5 years). The longer term presents a greater risk of a fall in the price if interest rates had to go up. In addition, it is easier to assess the viability and financial strength of the government over a 5 year period than it is over a 14 year period. This adds to the higher yield being offered on the longer dated MGS.

The above is explained much better in a recent post of mine which discusses Are Bond still Worth Investing Into? In this post I give a practical example of what would happen to the price of the 3.00% MGS 2040 if in 5 years time we had to experience a rise in the base rate to 2.50% (as it was just a few years ago). The result was that the price would go down to around €75 per 100 nominal!

This example serves to show that even the issuers that are regarded as the most safe present a risk to investors. Although the likelihood of a default from the government of Malta is very small, there is still an interest rate and maturity risk present that could have an effect on the investor’s return.

Are there any new Bond Issues?

Luckily Yes, We have Hili Properties which is the property division of the Hili Group which have just announced a €37mln bond with an interest rate of 4.50% maturing in 2025. Furthermore, Bank of Valletta have just announced that they will also be coming to the market with a maximum amount of €150mln in new bonds to be issued over the coming year (most likely the first in this series of issues will be this year).

Hili-_0002_hili-properties (1)BOV

How do the Corporate Bonds compare to the Government Bonds?

There are many factors one needs to consider when deciding between investing in corporate bonds such as the Hili Properties and the BOV bond issues, versus the MGSs discussed above.

Relative Risk

From an issuer point of view the MGS are regarded as relatively safer than the corporate issuers, but this is just when it comes to default risk. If we had to compare the 2.3% MGS 2029 to the 4.5% Hili Properties 2025 the MGS is longer dated and hence presents more interest rate risk and more maturity risk. Nonetheless even the Hili Properties bond is regarded as a long dated investment since it has a maturity of 10 years. Thus should interest rates go up in the next ten years, both the Hili Properties bond and the MGSs would be negatively affected.

Resale Opportunity

The MGS have the advantage when it comes to selling them once bought since the CBM creates a market for MGSs by offering to buy them back at set prices on a daily basis. Having said, it is no secret there is currently high demand for almost any bond on the local market so it would not be envisaged to be difficult to sell the Hili Properties bond in the short term.

Capital Gain Opportunity

Both the MGSs and the corporate bonds would present an opportunity for capital gains, especially in the short term. Keep in mind that the government will be issuing €180mln of new bonds which is essentially new supply of MGSs. In basic economics we know that as supply grows the price of the object will go down. For this reason we would expect the price of the new MGS to be slightly lower than the current market prices. At the same time, virtually every time a new MGS has been issued the price has gone up on the market. Why? Simple – virtually every time the MGSs were issued they were over-subscribed meaning that there was a surge in demand. Back to basic economics, as demand goes up so does the price of the object.

With the corporate bonds the case is normally that the issuing price will be €100 per 100 bonds (i.e. no premium). Based on the same theory as the MGSs, there is normally an over subscription for the bonds and this in turn leads to an increase in the price, and thus a chance to sell at a  profit.

A simple introduction to bonds video can be displayed below:

The Bottom Line

One must be careful however here, what I have discussed in the above two paragraphs is an expectation over the first few days to weeks of the life of the bond/MGS. It may well be the case that new news comes to the market which could have a positive or a negative effect on the prices of the then issued bond/MGS. At the same time, there is no guarantee that the bond or the MGS would be oversubscribed. Even though past data suggests so, we all know the famous warning that past performance is not a guarantee of future performance and the value of your investment could go up as well as down.

As usual I must stress that this article is not intended to be used as investment advice and reference to the respective prospectuses should be made prior to investing in any of the instruments mentioned. Furthermore, Please refer to the Full Disclaimer.

Are Bonds Still Worth Investing Into?

Money

It is no secret that in Malta investors tend to prefer fixed income products and tend to shun away from investing into shares, even more so if they are foreign shares. However, given the current scenario where interest rates are virtually as low as they can be and with the possibilities of rate increases in the coming months/years – does it make sense to be 100% in fixed income?

What do low interest rates mean for fixed income investments?

The fact that interest rates are low presents two major problems for fixed income investors. Both problems are intrinsically tied to the inverse relationship between bond prices and interest rates. As was discussed in a recent post when interest rates fall, the price of existing bonds rises. This has been in effect over the last years, since central banks around the world have been cutting interest rates and the prices of bonds have been rising. 

What this means for an investor who wishes to buy a bond is that prices are high and yields (i.e. returns) are low. In some instances, such as certain German Government bonds, we even have a situation of negative yields. This means that if you buy the bond, since the price is so high and it will eventually mature at a price of €100 per 100 bonds, even if you consider the annual return from the interest you will receive, you will still end up with less money. 

This is just one of the problems when faced with low interest rates. The other major problem is that if an investor holds bonds currently, once interest rates start to go up, the prices of his bonds will go down. An important factor to consider here is the fact that the more longer dated the bond is, the higher the risk of the price of that bond going down. So even if an investor buys a really safe bond that has very little risk of defaulting, that investor would still have to suffer a capital loss if he/she wanted to sell his/her investment before maturity.

hands-with-plant-money-296319

So to sum up, if an investor buys a bond today, such an investor would be earning a low interest return and would also be taking on the risk of being stuck with that low return even if interest rates go up.

An Example of a Long Dated Bond and an Interest Rate Increase

Let us take as an example the latest issue of the Malta Government Stock (MGS). Earlier this year the government issued a 3% bond that matures in 2040, making it a 25 year bond. The bond is currently trading at a price of €106.50 per 100 bonds. So basically anyone who bought it at a price of €100 when it was issued, is currently making a profit of 6.50%.

As a new investor however, if one wanted to buy into these bonds, such an investor would be paying a premium of €6.50 per 100 bonds bought since at maturity the bond swill pay out €100 per 100 nominal. So there would be a known one time capital loss of 6.50%. However, one would also earn 3% per annum on the nominal amount of bonds bought. By using a YTM Calculator we can easily work out that the yield to maturity would be around 2.65% on this bond. This means that if the investor buys the bond today and holds it until it matures he/she would earn an equivalent of 2.65%.

Now imagine that 5 years pass and the base rate, (that is, the rate set by the central bank on which other interest rates are based), goes up from the present 0.05% to say 2.50%. So as a quick rough estimate, if with a base rate of 0.05% the government of Malta can borrow until 2040 at a rate of 2.65% (the YTM). Then if the base rate goes up to 2,50%, the same government of Malta would have to offer around 5% interest on a bond maturing in 2040.

So how would this affect our current bond holder who bought the 3% MGS 2040? Badly – very badly.

If an investor could earn 5% on a new government bond that matures in 2040, the yield of the existing government bond he holds has to go up to 5% as well. For the yield to go up to 5% on our original 3% MGS 2040 bond the price has to go down so that new investors can make a capital gain on top of the 3% per annum interest. One might reason that this difference would not be that much since the difference between 3% interest and 5% yield is just 2%. The problem is that 2% difference has to be achieved over a period of 20 years!

So if we simply use a Bond Price Calculator to see what price the 3% MGS 2040 has to be in order to yield 5% if bought in 2020 we get a result of around €75! This means that the bond holder who opted for the long dated yet very safe investment can only sell his investment for a loss of around 30% (considering it was bought at €106.50 and sold at €75). One may argue that if the investor does not sell the bond and simply keeps it, that investor would just lose the 6.50% capital loss and still earn his full 3% per annum. This is true, however it must be pointed out that the same money that is earning that investor 3% per annum could have been earning him/her 5% per annum in our scenario. Multiply this 2% difference by 20 years, that is a total difference of 40% in interest lost.

quick-tasks-increase-income

This example begs the following questions:

  • Are local bond investors prepared for interest rate increases?
  • Is the local bond investor mature enough to recognise the different types of risks involved in investing into bonds besides the obvious risk of default of the issuer?
  • Are investors buying any locally issued bond recklessly?

The Bottom Line

At the end of the day, investors seeking a fixed income have come to accept the fact that interest rates are low and will probably remain so for the coming years. Although interest rate increases are expected from next year in Europe, they are not expected to be drastic and nobody really knows when and if they will actually happen.

Furthermore, investing into bonds still is normally considered one of the safest options, however one has to appreciate that there other risks when investing into bonds besides the risk that the issuer defaults. In practice the default risk as it is known is one of the least factors that affects investors since through diversification and through the selection of good quality issuers this risk is normally seen to. In reality most investors are currently mainly subject to interest rate risk and maturity risk. I had already discussed the risks of investing into bonds in a recent bonds which you can access here.

KD

YTM and Bond Price Movements

 

Bond YTM

In connection to last week’s post about Bonds vs Bond Funds a good follow-on mid-week post would be a short discussion on what we understand by a bond’s yield or yield to maturity . Once we understand this concept better we can then go on to see how bond price movements can be explained better.



The Basics of a Bond

Lets start with the basics, a bonds as we discussed is essentially a loan. So it is a debt obligation with a maturity of more than  one year. When for example a company wants to make a long-term investment, of say opening up a new plant, it can borrow the money from investors by issuing a bond. In return it promises to pay a series of pre-determined interest payments and the original value of the loan at the end. In technical words the interest payments are known as the coupon, the end date is known as the maturity date and the final value or original capital is know as the principal, face value or par value of the bond.

Once a bond has been issued to investors, it is then traded in the bond market. Therefore, although a bond may have a maturity of 10 years for example, an investor can cash in his investment earlier by selling the bond on the market. A bond’s par, or nominal, value is typically €100, however its actual value will vary according to the cash flows it pays (interest and repayments) and the prevailing rate of interest for the type of bond. The fair price is the present value of the future interest and final capital payment.

Value of a Bond = Present Value of the interest payments + Present Value of the principal value

Present Value

In simple terms the present value of any cash flow is the current worth of such future cash flows, As you often hear people say “€100 today is not the same as €100 in 10 years time”.  This is all related to the concept of the Time Value of Money. There is a price to lending money to a firm by buying a bond. Therefore, the return paid by a bond must reflect the time value of money, and it comprises:
(a) the risk-free rate of return rewarding investors for forgoing immediate consumption,
plus
(b) compensation for risk and loss of purchasing power.

Yield to Maturity (YTM)

To understand the concept of yield or yield to maturity we must first recognise that the return an investor received form a bond is not just the regular coupon payments (which we will assume are always fixed), but also the capital gain or capital loss that the investor would benefit from or lose from. This capital gain or loss is directly related to the price at which the bond is purchased. So if for example I buy a regular bond that has a €100 maturity value, but I buy it at a price of €95, then at maturity I will eventually make a capital gain of €100-€95 = €5 per 100 bonds I own. On the other hand, if I buy the same bond at a price of €105 per 100 then at maturity I will eventually make a capital loss of €100-€105 = -€5 per 100 bonds I own.

When one buys a bond below its par value it is said that one has bought the bond at a discount. On the other hand if the bond is bought above the par value then it has been bought at a premium. This is why the YTM is such an important concept. The YTM tells you the true return that you will make if you buy a certain bond that has a certain interest for a certain price. An example will clarify this better.

YTM – an Example

Imagine company LOL Ltd had issued a 5% bond last year with a maturity in 2024 and the bond is currently trading at a price of €109 per 100 on the market. As an investor I would know that if I buy this bond today I will be losing €109-€100=€9 per 100 bonds I buy. I also know that I will lose this value once the bond matures in 9 years time and pays the €100 back to me. In the mean time I am earning 5% on every bond that I bought. So if we ignore the present value complication we can estimate that roughly I will be losing around 1% per year (€9 capital loss that will be realised in 9 years time) but I will be gaining 5% per year from the coupon. Hence my true interest rate is roughly 5%-1%=4% per year. This 4% is the yield or YTM on this bond. In reality the calculation is a bit more complicated but you can easily get the figure by using a YTM calculator.

Therefore, when an investor wants to decide if it is worth investing into a bond that is trading on the market it is important for that investor to consider the YTM and not simply the coupon rate. The YTM gives you the full picture since it considers both the interest income and the capital gain or loss.

YTM and Bond Price Movements

By understanding this very important concept it is now easy to understand why bond prices go up when interest rates go down and vice versa. Lets go back to our example of the 5% LOL Ltd 2024 bond. When LOL Ltd issued the bond last year the price it issued it at was €100 per 100 bonds. At that time, 5% was the market rate of interest on a bond issued by any company with the same risk as LOL Ltd, that also had the same maturity in years as this particular bond. Now lets us consider that the central bank decided to increase interest rates and so the market interest rate on a bond issued by LOL Ltd that also matures in 2024 is now 6%. What would a rational investor do in such a situation?

So you have the following options:

  1. Bond A – 5% LOL Ltd 2024
  2. Bond B – 6% LOL Ltd 2024

Any investor who held the original bond would want to sell it immediately so that they could buy the second bond. Why? Simple really, for the same risk and the same amount of years the rational investor would prefer to earn 6% rather than 5%. This brings us to the most basic concept in finance – any price of any investment is ultimately determined by demand for and supply of that investment.

Bond YTM

Therefore, as investors start to sell the 5% bond the supply of this bond on the market will increase which will consequently bring about a fall in the price of that bond. Conversely, as many investors are now trying to buy the 6% bond the demand for this bond is increasing and ultimately its price will go up.

How much will the price of the 5% bond go down and how much will the price of the 6% bond go up? The answer to this should be simple now, the prices will change until the yield on both bonds is the same, why? Since both bonds are issued by the same company and are for the same amount of years (i.e. they have the same risk), they should technically pay the same return. In our example, we can assume that the price of the 6% bond will rise until the yield on it is 5.5%, while the price of the 5% bond will fall until the yield is also 5.5% on this bond.

A simple video to help you understand YTM better:

A final word of caution is that YTM is valid only, as the name states, assuming that the bond will be held until maturity. If an investor sells a bond before its maturity date that bond could be trading at a higher or a lower price to what it would had been bought at. Therefore, the YTM should only be considered when the intention is to keep the bond until maturity and of course, assuming there is no default.

A great use of the YTM is to be able to compare the expected return an investor could earn from different bonds that have different coupon rates and different prices. Since the YTM gives you an annual ‘total’ return figure, you can easily compare the YTMs of different bonds to see which one would give you the highest return. Of course return is just half the story, one also has to consider the risk involved – but that is a total other discussion in itself which will be covered in a separate post.

Please remember to subscribe on the left hand side of the page to be able to received regular updates directly. You can also share this or any other post on your favourite social media places by using the buttons below the post.

KD

Direct Bonds vs Bond Funds

Money Building

It is no secret that for the local investor the preferred choice of asset class is normally the Fixed Income class. Fixed Income investments generally pay a fixed or quasi-fixed return on a regular, pre established basis. The assets class encompasses many different sub-categories such as:

  • Direct Bonds – which make interest payments and repay the principal on a fixed schedule. Interest and principal payments are subject to the creditworthiness of the issuer.
  • Bond Funds – invest primarily in individual bonds. Many make periodic dividend payments based on the interest paid by the bonds held in the fund.
  • Fixed Income ETFs  – Exchange-traded funds (ETFs) are baskets of investments that trade as a single unit throughout the day.
  • Money Market Funds –  are managed to help preserve your principal by investing in lower-risk debt securities with shorter maturities.

This post will focus mainly on the two most preferred genres of direct bonds and bond funds.

Direct Bonds

A bond is essentially a loan issued by a corporation (company) or a sovereign (government). The issuer of the bond will normally agree to pay a fixed or variable interest known as a coupon at fixed time intervals, for example annually or semi-annually. A bond will have a pre-determined maturity date at which point its face value will be paid which is normally the same price it would have been issued at.

Please refer to the below video for a quick visual explanation of the basic features of a bond:

Why would a company want to issue a bond rather than go to the bank? First of all there is the issue of cashflows required to service a bond as opposed to the cashflows required to service a bank loan. With a regular bank loan the company would have to pay interest plus capital on a regular basis, normally monthly. Granted there are interest only loans which will allow for a short period where only the interest payment needs to be made.

On the other hand, when issuing a regular bond it is only the annual or semi-annual interest payment that needs to be paid. If the company is successful and investors still want to remain invested in the company the bond issuer can simply roll over the bond at the end of the term and not have to pay the capital at all. This means that the issuer will issue another new bond to pay for the old bond.

In the years after the 2007-2009 financial crisis, on the local market we have seen many new bond issues, especially given the lower interest rates that prevailed. This has even caused a wave of roll-over issues especially on bonds that had a callable date and that were issued at a higher interest rate previously. a callable date is simply when a bond has more than one fixed date when it can mature. At the option of the issuer the bond may be matured (or called in) at an earlier date than the final maturity date.

Imagine it is 2005 and a company issued a bond at a rate of 7% maturing in 2012-19. Since in 2012 interest rates were much lower than they were in 2005 it would make perfect sense for the company to issue a new bond, say at an interest rate of 5% and use the proceeds to pay off the old bond. Considering that an average local corporate bond would be for around €30 million, that 2% saving in interest would result in a €600,000 annual cost saving.

One has to also keep in mind that not all bonds are the same. Every issuer has its own set of risks and generally speaking

“The higher the interest rate offered, the higher the risk involved.”

Even the same issuer can have different ranking bonds ranging from senior, secured, un-subordinated to junior, unsecured, subordinated. These terms are all referring to the ranking of the bond in the event of a default of the issuer. One must also keep in mind that a senior bond of one issuer is not necessarily less risky than a subordinated bond of another issuer. For example, what would you consider more risky: a subordinated bond of a well established bank which is highly regulated and has a strong capital base, or a senior bond which is issued by a small company that operates in the IT sector?

Bond Funds

Bond Funds are basically portfolios of direct bonds put together. So when you own units in a bond fund you are essentially owning part of a portfolio of many different bonds. Bonds held within the fund portfolio are designed to mature on a staggered basis so that income payments are delivered consistently.

A bond fund would have a fund manager who will be responsible to take the investment decisions within the fund. The fund manager replaces bonds as they mature, when the issuer’s credit is downgraded and when the issuer “calls,” or pays off the bond before the maturity date. The fund manager could even have profit targets at which point they would sell a holding. Alternatively bonds could be sold since the outlook of the issuer is no longer favourable.

Some bond funds are designed to mimic the broader market, while others specialize in high-yield (riskier) bonds, short-term debt, emerging markets or governments bonds. Some focus on certain geographical locations or issuing currency of the bonds.

Bond funds typically pay out interest payments on a regular basis which is normally monthly or quarterly. The income paid would be coming from the income earned by the fund. A major difference between a bond fund and a direct bond is that a bond fund does not have a maturity value at which point the capital would be returned as in the case of a direct bond.

Risks associated with Bonds & Bond Funds

A way to gauge the risk of a bond that has been used for many years is to look at the bond’s credit rating. Credit rating agencies like Standard and Poors, Fitch and Moodys are in the business of assessing a company to determine how risky it is as an issuer. They then use their own credit rating scores to determine the riskiness they perceive vis-a-vis that issuer.

The below table gives a detailed definition of the different ratings:

Chart-1-new

 

Of course credit ratings are just covering one type of risk involved in investing into bonds which is defined as default risk. This refers to the risk of the issuer defaulting on payments and being forced to restructure or file for bankruptcy. There are other risks involved with investing into bonds which include:

  1. Interest Rate Risk – Interest rates and bond prices have an inverse relationship; as interest rates fall, the price of bonds trading on the market normally rises. On the other hand, when interest rates are rising, the price of bonds tends to fall. This happens because when interest rates are on the decline, investors try to capture or lock in the highest rates they can for as long as they can. To do this, they will buy into existing bonds which have a relatively higher interest rate than the prevailing market rate. This increase in demand results into an increase in bond prices. Conversely, if the prevailing interest rate were on the rise, investors would naturally try to sell their existing bonds that now would be paying a relatively lower interest rates. This would force bond prices down.
  2. Reinvestment Risk – the risk of having to reinvest proceeds at a lower rate than the funds were previously earning. Many investors have experienced this over the last 5 years or so when interest rates fell over time and callable bonds were exercised by the issuers. Active bond investors can attempt to mitigate reinvestment risk in their portfolios by investing into bonds with different maturity/call dates. This limits the chance that many bonds will mature or be called at once.
  3. Inflation Risk  this occurs when the cost of living (or inflation rate) erodes the real return that an investor earns. This risk is quite present at the moment. If an investor buys a bond that pays a fixed 1.5% interest but the inflation rate is at 2% then the real return is -0.5%. 
  4. Liquidity Risk – this is the risk of not being able to sell your bond. Government bonds are generally easier to trade, but corporate bonds, especially in times of panic could be quite difficult to trade.

The Bottom Line

So considering all the above, which is better to invest into at the moment, bonds or bond funds? Like many cases in finance it all depends and a combination of the both is most likely the ideal option.

Bond funds have the advantage that they offer a diversified portfolio at a much smaller capital investment than if one had to make up a similar portfolio on their own. So for an investment of say €5,000 you can invest into a bond fund that would be invested into 200 different bonds for example. A bond fund will be managed by the fund manager who would be active in balancing the portfolio in order to take advantage of market situations and hedge against potential adverse movements. This might be difficult to do with a portfolio of direct bonds since the investor might not have the time or expertise to do so.

An advantage of direct bonds is that they have a maturity date at which time (excluding default of the issuer) the face value of the bond would be paid. With a bond fund, it is like holding a perpetual investment with no end date. However the bonds within the fund will have a maturity date and the duration of the fund is an important feature to note when choosing a bond fund. In simple terms a bond’s duration is the amount of time in years it would take to get back the investment made to buy that bond.

What about the cost? Generally speaking bonds are cheaper to buy. An international bond will normally cost around 1% whereas local bonds are even cheaper to trade. With a bond fund they normally have around 3-5% as an upfront fee and an annual management fee of around 1% that is taken form the fund. Why do bond funds have such higher costs? Essentially it is the same reason why bond funds can be a better choice – cost of the fund manager, their teams in charge of research and sales and also the charges of the broker have to be recuperated through these fees. Like with many things in life, nothing of good quality comes free in the world of finance.

Taking a more practical view now, in the current situation where we have

  • very low interest rates,
  • prospects of interest rate increases possibly from next year (keep in mind that as interest rates rise the prices of existing bonds normally falls),
  • low liquidity in the market to buy direct bonds (investors that hold existing bonds are reluctant to sell them knowing that yields have fallen).

What should an investor opt for? If the investor is looking for regular income (example monthly or quarterly), looking for a diversified portfolio to spread his/her risk among different issuers and wants to get a full allocation of the money he/she wishes to invest immediately, then based on the above a bond fund is looking most attractive for such an investor. It is however important to note that not all bond funds are the same. One has to look for large bond funds with a decent spread of different bonds and a health level of cash balances. It is also important to have a bond fund with a track record to see how the fund performed in normal, difficult and good times. Another important feature is the duration of the bonds within the fund. Given the current interest rate scenario it is important to stick to bond funds with short durations, say 3-4 years since these will face lower risk when interest rates do increase. Finally it is important to check which are  issuers the  bond fund is investing into. This can easily be found on the annual accounts of the fund and the top 10 holdings of the bond fund are normally found on the fund’s fact sheet.

So should direct bonds be disregarded, not quite. Unfortunately on the local market new bond issues are being so over subscribed that an investor wanting to invest €10,000 is normally being left with around €1,500 to €2,000 allocation and receiving the difference back as a refund. This is not an issue with bond funds since the exact amount desired is normally easily purchased or sold within a few business days. Direct bonds can also be bought on the market (i.e. buy buying existing bonds). Granted, the prices of existing bonds are quite high at the moment, however one has to consider the yield the bond is paying and not just the price one is paying for it. So when considering the “high” price of the bond and the coupon it is paying, is the yield still attractive?

What about Malta Government Stocks (MGSs)? There is still some money to be made here, but I will focus on this topic in a whole separate post dedicated to MGSs.

For more info on this or any other finance related topic, please do not hesitate to contact me on kd@financebykd.com or by using the Contact KD form on the site.

KD