The role of the capital market

Article #699 by Edward Rizzo - Published Weekly

Malta’s capital market commenced operations in 1992 so it still a relatively young market.

During the past 29 years, the corporate bond market in Malta developed at a much more rapid pace than the equity market when considering the number of issuers approaching the market. However, in terms of market value, the overall value of corporate bonds listed on the Main Market of the Malta Stock Exchange currently stands at €1.9 billion while the overall market cap across the equity market is of €4.4 billion.

An important distinction when discussing the function of the capital market is between the primary market and the secondary market. The primary market deals with the issuance of new shares and/or bonds essentially helping to channel surplus funds from savers to companies/institutions which then invest them into a more productive use. When a financial instrument is issued via the primary market, one generally refers to such issuance as an Initial Public Offer (IPO) or a public offer.

The secondary market is the platform dealing with the exchange of existing or previously issued shares and/or bonds between participants such as individuals and institutions via authorised financial intermediaries or members of the stock exchange.

Essentially, one of the main functions of a capital market is to act as a link between savers (whether retail or institutional) and companies seeking to finance their businesses and long-term investments. This intermediation process is a very important role as it boosts economic growth and enables savers to build a portfolio of financial instruments across various industries. Moreover, the capital market enables observers to obtain a valuation of a financial instrument and provides liquidity through the availability of the regular trading of such securities via the secondary market.

In the initial years of the MSE and until the international financial crisis in 2008, the interest rate environment was totally different to what we have experienced over the past 10 years. In the past, several Maltese investors managed a good portion of their wealth via fixed deposits of different maturities across a number of banks and only utilised the capital market for a small portion of their overall wealth.

As interest rates declined steeply over the past 10 years, more Maltese investors felt the need to utilise the capital market in a more meaningful manner since the interest rates on fixed deposits declined to extremely low levels making it unattractive to lock their savings for a number of years. As such, those investors seeking to improve income generation on their savings needed to obtain added exposures to the bond and equity markets.

This large amount of excess liquidity in the banking system led to a meaningful growth in the Maltese corporate bond market as companies also noticed the sizeable demand from retail and institutional investors. The equity market grew at a much slower pace although the share offerings by PG plc in 2017 and BMIT Technologies plc in early 2019 were very important transactions for the development of the Maltese capital market also in view of the introduction of ‘new’ economic sectors to the local equity market.

The more active role of the capital market in the intermediation process between savers and companies requiring funding also led to a marked change in the way a number of companies viewed their funding requirements. It is amply evident from a number of transactions that took place over recent years that several companies understand the importance of having an appropriate funding mix between banking relationships and the use of the capital market. Another important advantage for companies investing in projects that will be executed over a long number of years or utilising the market for other long-term funding needs is the benefit from a cash flow perspective. While companies generally would need to repay capital on an annual basis to the bank, this requirement is not needed when issuing a bond on the capital market although the company would need to show a certain amount of resilience in terms of their overall debt to equity profile.

Unfortunately, many Maltese investors still believe that at times companies issuing bonds are either in a difficult financial situation or are having problems in raising funding from banks. However, it is important for such investors to understand the role of the capital market and the increased flexibility available to companies by having an appropriate funding mix in place. Moreover, another misconception is that companies need to repay their bond in full upon maturity. This is very much dependent on the sector in which a company operates in and the nature of the business. A company carrying out property development activities for example is very different to a hospitality or a telecoms company. In the case of a property development company that sells the properties once built, it is naturally important that sufficient cash is available to repay the bond upon maturity given the finite amount of property available for sale. On the other hand, companies with ongoing revenue streams always require a certain element of debt funding in order to maximise shareholder returns.

The most recent bond issue in Malta of GO plc is a clear testament to the effective use of the capital market. Given the strong credit metrics of the company and the significant amount of liquidity within the banking system with a large amount of excess deposits by retail and various corporate customers, it is no surprise that there was very strong demand for this bond issue. The investing public is clearly understanding the need to channel a greater amount of idle liquidity into the capital market especially into sectors which were not brutally impacted by the pandemic.

The strong appetite by the investing public for the GO plc bonds is good news for the capital market and also for those companies seeking to raise new or additional funds in the months ahead. Although the Malta Stock Exchange has not published an indicative calendar on the expected issuance by the end of the year, there are strong indications that a number of equity and bond issuers are willing to utilise the capital market in the months ahead.

Naturally, as advocated in the past, with investors obtaining direct exposure to various corporate bonds as opposed to having a large part of their wealth tied in fixed deposits, increased vigilance is required before investing. The pandemic has shown that certain industries can be materially impacted with significant pressures on the financial situation of a company. As such, a proper assessment of the financial soundness of a company and adequate diversification is of paramount importance for retail investors. Although the Maltese economy will remain very much dependent on financial services, real estate and hospitality (in fact these are the three most dominant sectors across the corporate bond market), hopefully the pipeline of new issuance that is likely to materialise will lead to a wider diversification across the market.

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This article was produced by Edward Rizzo, Director at Rizzo Farrugia, which is a company licensed to undertake investment services in Malta by the MFSA under the Investment Services Act, Cap. 370 of the Laws of Malta and a member of the Malta Stock Exchange. The company’s registered address is at Airways House, Fourth Floor, High Street, Sliema SLM 1551, Malta.