Monitoring bond issuer developments (6)

Article #518 by Edward Rizzo - Published Weekly

In the last of a series of articles reviewing the financial metrics of several local bond issuers, this week’s contribution examines financial services firms that have their debt listed on the Borza.

Firstly, it is important to highlight that financial services companies (namely banks and insurance companies) need to the analysed from a completely different perspective than other companies operating in different economic sectors. In fact, EBITDA is not a useful calculation for financial services companies since interest income and interest expenses are a critical component of the business model. Instead, financial analysts normally make reference to other important indicators when gauging the creditworthiness and financial strength of a financial services company, such as the level and sustainability of profits from core operations, the returns on equity, the efficiency and risks in asset-liability management (including the overall quality of assets held on balance sheet), and, very importantly, the level of conformity with regulatory requirements in terms of liquidity, leverage and capital adequacy ratios.

There are two other main differentiating factors associated with bonds issued by financial services companies. The revised Listing Policies dated 5 March 2013 stipulate that companies are exempt from publishing a Financial Analysis Summary (“FAS”) in cases where the issuer is subject to capital requirements as laid down in the EU Capital Requirements Directive or the Solvency II Directive – i.e. banks and insurance companies. As a result, all local financial services companies that have their debt listed on the Borza do not issue a FAS with the exception of GlobalCapital plc.

Another distinguishing factor is tied with the use of proceeds of the bonds. In this respect, whilst non-financial corporate entities normally issue bonds to finance a specific project or undertake an investment, or for instance, to refinance or restructure existing borrowings, in the case of senior bank debt, the use of proceeds could be the further diversification in the source and duration of funding – in other words for reducing the gap (and hence the risks) between long-term lending to customers (e.g. mortgages) and short-term funding from customers (e.g. on-demand deposits and term accounts).

In addition, banks may also issue subordinated debt in order to strengthen their respective capital ratios. This means that, as opposed to senior bank debt, subordinated bonds will form an integral part of the issuer’s capital structure in the form of Tier 2 capital. In this respect, it is also very important for investors to understand the meaning of subordination especially following the enactment of the European Bank Recovery and Resolution Directive in July 2014. In essence, subordination means that the rights and claims of any such bondholders in respect of the payment of capital and interest will, in the event of financial difficulties being faced by the issuer in question, rank after the claims of all senior indebtedness and will not be repaid until all other senior indebtedness outstanding at the time has been settled.

At the moment there are fifteen bonds issued by financial services companies listed on the MSE – six by each of Bank of Valletta plc and MeDirect Bank plc (formerly Mediterranean Bank plc) and one each by HSBC Bank Malta plc, Izola Bank plc and GlobalCapital plc.

Bank of Valletta plc is by far the largest corporate bond issuer having almost €327 million worth of bonds listed on the MSE. BOV’s Common Equity Tier 1 (“CET1”) capital ratio (which reflects the level of the highest form of quality capital that provides the greatest protection against losses) stood at 14.1% as at 30 September 2017. Although the bank is currently considered to be adequately capitalised by the regulatory authorities, BOV needs to strengthen its capital buffers in view of the more stringent requirements that will come into effect in January 2019. In this respect, early last month, the bank announced a rights issue of approximately €150 million which places BOV in a relatively much stronger position from a capital perspective going forward.

Over the years, BOV has consistently registered strong financial results, generated double-digit returns on equity, and also distributed attractive dividends on the back of its leading domestic market share and commanding franchise. BOV also made notable progress in recent years at improving the overall quality of its loan book. In fact, the amount of non-performing loans now represents only 3.6% of total loans from a recent high of over 7% following the conclusion of a comprehensive review and a clean-up exercise of legacy non-performing loans during the 2015/16 financial year.

On the other hand, however, BOV faces some important challenges including the adoption of the new accounting standard IFRS 9 which is set to come in force on 1 January 2018, the more efficient management of its growing balance sheet (BOV’s loan-to-deposit ratio stood at just over 41% as at 30 September 2017 compared to well above 60% in recent years), the overhaul of its core IT system (which is estimated to cost around €44.5 million over a five-year period up to 2021), the continued restructuring and de-risking of its business model, as well as the creation of additional sources of income amid a persistently stringent regulatory environment and an unfavourable interest rate scenario.

On its part, HSBC Bank Malta plc redeemed its €58.2 million 4.6% subordinated bonds on 1 February 2017. The bank’s other subordinated bond (which was coincidentally issued on 15 September 2008 – the same day that the US global banking giant Lehman Brothers filed for bankruptcy) matures on 7 October 2018. Similar to BOV, HSBC also has a long-standing history of strong profit generation and relatively generous dividend payouts. However, as the bank adopted a much more risk-averse business profile in recent years, coupled with the unfavourable interest rate scenario, HSBC’s level of profitability took a significant downturn. In fact, HSBC reported a net profit of “only” €40.2 million during the financial year ended 31 December 2016 which is almost half as much as the record net profit of €76.3 million posted in 2007. As a result of the declining profitability and the increase in equity, the Bank’s return on average equity slumped to just 8.6% in 2016 from 26.7% in 2007.

Although HSBC’s aggressive de-risking strategy adopted in recent years had various negative effects on profitability, at the same time it assisted the Bank to control the growth in the size of its balance sheet which, given the limited investment opportunities for banks today, has been beneficial for the bank to efficiently manage the relationship between its assets and liabilities. In fact, HSBC’s loan-to-deposit ratio stood at 66.2% as at 30 June 2017 which is a very good ratio compared to other local banks. Furthermore, HSBC Malta’s conservative risk culture and selective business approach permitted it to build a level of capital that is above the fully-loaded requirements without the need to revert to its shareholders for additional capital. Indeed, HSBC’s CET1 capital ratio stood at 13.9% as at 30 June 2017. In this respect, the Interim Directors’ Statement issued by the Bank on 20 November 2017 (the first one after two years) stated that the Bank has now commenced a review to assess how best to deploy its capital going forward.

Some investors may be surprised by the fact that the holding company of MeDirect Bank (Malta) plc – MeDirect Group Limited (formerly Medifin Holding Limited) which is majority owned by the UK private equity firm AnaCap Financial Partners II L.P. – is also considered as a core (i.e. systemically important) domestic bank by the regulatory authorities. This means that MeDirect Bank falls under the direct supervision of the European Central Bank as it could have a considerable impact on the local financial system and the economy in general in the hypothetical scenario that it finds itself in financial difficulties.

MeDirect Bank achieved notable diversification in recent years following the acquisition of Volksbank Malta Limited (2014) and Charts Investment Management Service Limited (2015). In parallel, the bank also expanded internationally through its Belgian subsidiary. As at 30 September 2017, total assets amounted to €2.53 billion, of which €1.56 billion (61.5% of total assets) is composed of loans and advances to customers whilst €595.8 million (23.5%) relates to investments. On the other hand, the bank had customer deposits of €1.92 billion as at 30 September 2017, translating into a loan-to-deposit ratio of 81.3%. Meanwhile, the bank’s CET1 and Capital Adequacy ratios stood at 11.7% and 13.7% respectively as at 31 March 2017.

Izola Bank plc is owned by the Van Marcke Group which in turn is a family-owned business with interests in the supply of wholesale plumbing, heating and sanitary ware in Europe. The bank mainly services the trading and financial interests of the Van Marcke Group and has a positive track-record in terms of profitability and capital adequacy. Although Izola Bank is considered to be a very small bank when compared to BOV, HSBC and MeDirect Bank, its balance sheet size expanded considerably in recent years. In fact, total assets reached nearly €196 million as at 30 June 2017 from €95.4 million as at the end of 2012. The bank’s assets mainly comprise loans and advances to customers (representing 34% of total assets as at 30 June 2017) and investments (33%). Moreover, the bank had a total of factored receivables amounting to €23.4 million as at 30 June 2017.

GlobalCapital plc is the only insurance company that has its debt listed on the MSE. The company specialises in the provision of life and health insurance products as well as investment-related services. GlobalCapital went through a restructuring process in recent years as the company divested itself from non-core business activities. In 2016, GlobalCapital performed a capital raising exercise through a €4.74 million rights issue. These funds were used to partly finance the redemption of the 5.6% bonds due on 2 June 2016. In addition, GlobalCapital had indicated earlier this year its intention of conducting another rights issue of an amount not exceeding €15 million by the end of this year, subject to regulatory approvals, in order to meet its general financing requirements, strengthen its balance sheet (following the significant losses incurred some years ago) and eventually be in a position to repay its €10 million unsecured bonds maturing in 2021. In 2015 and 2016 GlobalCapital posted a net profit of €4.12 million and €1.85 million respectively. Moreover, the FAS dated 20 June 2017 shows that the company is expecting to register a net profit of €2.45 million during the current financial year ending 31 December 2017.

With 2017 now practically behind us, investors eagerly await developments in the new year particularly with respect to the possibility of new investment opportunities on the MSE. Following the various new names that tapped the local capital market in 2017, one hopes that more companies will consider bond and equity offerings during the next 12 months. Meanwhile, market participants need to continue pursuing initiatives aimed at increasing the overall profile of the MSE including achieving higher levels of liquidity for the benefit of all investors. Moreover, companies that are already listed on the MSE ought to aim at increasing the level and frequency of their communications with the market. Ultimately, a healthy and vibrant local capital market is indeed a very important tool for Malta to continue registering economic success going forward.

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