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

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