Understanding bond market terminology

When I started publishing articles in the media just over 17 years ago, one of my main aims was always to assist in educating the investing public. In fact, over the years, I regularly explained some important terms used across financial markets and the applicability when it comes to assessing issuers whose securities are listed on the Malta Stock Exchange (MSE).

I was therefore pleased, but also surprised, when I was recently stuck in traffic and happened to listen to an advert on a local radio station in which they spoke about the bond market. The advert questioned what would happen to an investment if the company issuing a bond goes bankrupt. To which the advert indicated that an investor can ‘choose between secured and unsecured bonds’. The concluding remarks of the advert stated that ‘with secured bonds you have better protection in case of bankruptcy’. While I initially thought this was an advert from one of the many new secured bonds becoming available to investors (some of which are unlisted bonds and not tradeable on the MSE), it turned out to be an awareness campaign by the Malta Financial Services Authority (MFSA).

I was greatly surprised at the choice of words used in bringing awareness to the public about the bond market. My immediate thoughts were about a number of media articles I wrote over the years which specifically targeted this subject due to the misconception in the market on the important terms used when investors grapple with the bond market. In fact, I clearly recalled a specific article titled “Investing in Bonds: It’s not all about security!”. It turns out that this article was published just over 15 years ago, on 29th October 2009, and it is with great disappointment that despite my own efforts over the years to educate retail investors, my interpretation of the current media campaign by the MFSA to the investing public partially conflicted with my thoughts.

If there were other retail investors that happened to be listening to this same advert which is also available online, I think I could safely conclude that in the future they would always choose a secured bond over an unsecured bond. I also reflected on the feelings of the directors of some of the bond issuers in Malta that have unsecured bonds listed on the MSE and how their company is now being viewed in this context. Incidentally, some of these companies happen to be among the most profitable companies across the local capital market such as Simonds Farsons Cisk plc, GO plc and Premier Capital plc (Hili Ventures) just to name a few.

In view of this, I thought I must reiterate my beliefs to bring across an important message that I believe is not being covered in this campaign.

In my articles on the bond market, I always stated that before considering an investment in a secured or an unsecured bond, an investor should start by trying to assess the financial strength of the company issuing the bond. My thought process would not be one where I choose a secured bond simply to have a better protection in case of bankruptcy. Investors should steer away from that eventuality and invest in companies which are strong enough at the outset and unlikely to face default procedures

The prospectus as well as the Financial Analysis Summary which provides a good overview of the issuer, its business model and some key financial metrics, have sufficient details to conclude whether a company possesses an elevated level of risk or otherwise and whether it should be able to honour its commitments to bondholders in the form of annual interest payments and capital upon maturity.

The financial intermediaries involved in the distribution of such bonds should also have the capabilities to guide investors accordingly when requested to do so by an investor.

There are a number of financial ratios that are published in a Financial Analysis Summary which should provide sufficient insight into the financial strength of an issuer. The annual publication of such an important document should also provide the necessary information on an ongoing basis on the status of an issuer of bonds. In my view, the assessment of the financial robustness of a company should not only be done at the outset of the investment process but during the lifetime of the bond. Also worth stating is that some financial ratios are more adaptable depending on the type of company being studied.

When a bond is secured, the ‘security’ usually takes the form of a hypothec on property in favour of bondholders. While this is beneficial since it provides some comfort to investors in the eventuality that the issuer defaults on its obligations to bondholders, this should not be the most important attribute one must look into when analysing the attractiveness of a bond. The security feature would only be used as a last resort in times of financial difficulties and it is certainly not right in my view to conclude that unsecured bonds are riskier than secured ones. In fact, there are many unsecured bonds listed on the MSE that have much less credit risk than a number of the secured bonds.

The consumer awareness campaign by the MFSA also touches upon the wording ‘guaranteed’ that sometimes features in some of the bond issues. The MFSA states that “not all bonds guarantee the return of your principal”. Any reference to a ‘guarantee’ should not be misinterpreted by the investing public. In fact, the radio campaign explains that “when bonds are guaranteed, it means that a third party promises to pay if the issuer can’t”. Some companies issue bonds via a special purpose vehicle (a finance company) which borrows money from the investing public and on lends the funds to the parent company or other companies forming part of the wider group structure. In such cases, the bonds are guaranteed by the ultimate company borrowing the funds and it is important to analyse the credit metrics of the guarantor rather than the finance company. In a nutshell, the reference to a ‘guarantee’ does not imply that the bonds will be repaid under all circumstances and that an issuer may not default when the bonds are guaranteed.

Although I appreciate that the terminology in financial markets can be confusing to many retail investors, it is important to clarify the main terms used. It is clear that a growing number of investors are not performing any sort of analysis on the credit risk of an issuer or the group companies that may be ‘guaranteeing’ the bond. Relying solely on features such as ‘secured’ or ‘guaranteed’ is surely not the right form of investor education. Several issuers clearly have excessive levels of borrowings which can present stiff challenges in due course. Investors need to remain extremely vigilant given the growing number of bond issuers in Malta.

Read more of Mr Rizzo’s insights at Rizzo Farrugia (Stockbrokers).

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