Monthly Archives: July 2016

Fixed Income

Are Secured Bonds Safe?!

Leave a comment

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

Fixed Income

MIDI Plc vs IHI Plc – a Bond Comparison

1 Comment

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