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.

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.

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

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