A few days ago, I had the pleasure to address a short presentation on what is a relatively new theme to locals, that is the prospects market and I also formed part of a panel discussion with fellow colleagues in an investors educational seminar organised by the Malta Stock Exchange. The focus of the presentation was mainly the admissions document, a document which incorporates all the necessary information an investor should be aware of before investing in a bond.
The idea behind the presentation was aimed at encouraging investors to put more effort in the so called admissions document prior to investing. Unfortunately, in my experience within the industry, I have been faced with, on numerous occasions, investors literally ignoring the content, apart from looking at the coupon and payment dates of interest, in cases where the issuer is admitting a bond instrument.
Indeed, not only in the prospects market, but also in the local main market and in foreign plain vanilla instruments whereby market participants invest, the admission document, also known as a prospectus or indenture should be given its due importance via an in-depth analysis.
Looking from a bond investor perspective, there are several aspects that one ought to consider before considering whether to invest or not, in order to access whether the risk-reward ratio is favourable, i.e. in simplistic terms whether you are getting paid for the risk being pursued.
The security aspect
Continuing on the fixed-income asset class, an investor should be aware whether the investment is secured with an asset, and if the asset’s value will suffice throughout the tenor of the bond as a security of the full bond issuance.
The ranking aspect
Another important consideration is the ranking aspect. In simplistic terms ranking is where the bond in question ranks in a debt structure. Importantly, an investor should be aware of any other outstanding debt, which ranks prior to the bond investment. For instance, usually companies do hold what in technical terms we call revolving credit facility (RCF), better known as an over-draft facility. Typically, an RCF ranks higher than a bond. Likewise are possibly other bank borrowing. Thus, it is important that investors also consider this aspect. If things go wrong, and a company defaults, the ranking aspect will come into play in terms of recovery rate.
The corporate structure
Typically, capital is raised through a financing vehicle. Despite this, it is a fact that investors are paid through the set financing company, ultimately the flows of cash are generated through subsidiary companies to which the proceeds of a bond are loaned. In simple terms, this means that the operations of the company are at guarantor level and not at the financing vehicle level. Thus, it is crucial that investors do monitor the operational leverage of a company and ensure that the business model is working out.
Unfortunately, this is one of the biggest unknowns for local investors. Covenants are split between affirmative covenants, i.e. what a company is imposed to do, for instance issuing financial statements, and restrictive covenants, what a company is restricted from doing, for instance not paying a dividend throughout the tenor of the bond.
The focus should be more on the latter, as this gives more confidence to investors that management can align its views from a business perspective and halt them from taking possibly risky decisions, which ultimately can negatively affect a business model. Believe me, given my experience within the international high yield sector, I have seen on numerous occasions foreign bond issuers taking irresponsible decisions, which adversely influenced a business model and eventually investors through a default.
Through an informal chat with a fellow colleague, we both agreed that we market practitioners should encourage issuers to insert these types of clauses, primarily to put more confidence in markets and secondly to restrict an issuer from being over optimistic and on-boarding risky decisions.
To conclude, in my view, the lack of time dedicated to delve into a prospectus is a very common mistake amongst investors. Presumably, investors believe that the countless document is a waste of time, in addition they also believe that the investment will work out well. That said in actual fact, if something goes wrong that document is crucial for investors to know their rights.
I think it is time that investors begin to take some form of initiative and interest, which will ultimately result in them acting more responsibly, by being more active in dedicating time to read thoroughly such important documents and ensure that first, they are comfortable with the investment and secondly that they are being paid for the risk being taken.
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