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!

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.

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