Understanding a bond issuer’s obligations

Article #635 by Edward Rizzo - Published Weekly

The performances of both the equity and bond markets over the past two weeks reflected the surreal circumstances we are living in and the huge level of uncertainty as most economies around the world came to an almost abrupt halt.

From various calls received in recent days, it is clear that there is a huge concern among the investing public about the health of the Maltese corporate bond market. Prices of a number of bonds listed on the Regulated Main Market suffered double-digit declines with some bonds also dropping below their par (100%) value. The concern seems to be widespread, irrespective of which sectors may be impacted most from the coronavirus and those which may not be severely impacted from the current difficult operating environment.

In many articles over recent years, I had explained a number of metrics that investors should use in order to gauge the strength of a bond issuer or guarantor. These ratios were mainly based on the earnings power of a company and the ability to service debt obligations and repay borrowings upon maturity. However, given today’s extraordinary circumstances, ratios based on a company’s earnings are not a useful guide given the very low level of earnings that will be generated in 2020. Instead, one needs to assess other factors which can enable a company to be in a position to continue to service its obligations.

Before going into further detail on this, it is first important for the investing public to understand the obligations of a bond issuer. When an investor lends money to an issuer, the company has an obligation to repay interest on a periodic basis and also capital upon maturity. This is not a discretionary commitment and is a totally different story from dividends paid to shareholders which can be cut or cancelled even at short notice (as Malta International Airport plc announced last week that it may reconsider the proposed dividend at an Extraordinary Board Meeting on 22 April 2020). The delay in the repayment of interest on a bond constitutes an ‘event of default’ which is surely what all companies will do their best to avoid.

In view of the current extraordinary circumstances, investors need to consider the following four factors to gauge the ability of an issuer or guarantor to honour their commitments, namely (i) the financial leverage of a company; (ii) the operational leverage; (iii) the timing of the maturity of the borrowings and (iv) the financial strength of the shareholders.

As such, before seeking to rush for the exit in an indiscriminate manner, investors should be asking themselves whether a company’s balance sheet can take on a temporary increase in indebtedness to cover probable cash shortfalls until some level of normality is restored in their business operations. Moreover, can companies with high fixed costs take drastic measures to reduce costs quickly? If a bond matures in more than 5 years’ time for example, is the company in a position to survive and therefore have sufficient time to generate the necessary cash to honour its obligations? Are the shareholders strong enough to inject additional funds into the company?

Although issuers are understandably working around the clock to ensure business continuity where possible and take all necessary measures and precautions in these unprecedented times, they must also seek to provide the answers to these questions to enable an investor to be in a position to take more informed decisions. In such times, investor relations becomes even more critical.

Over recent days, the Maltese market was inundated by the ‘COVID-19’ company announcements in response to a circular issued by the MFSA on 13 March 2020. Unfortunately, most announcements almost replicated the same wording on the importance being given to operate in line with the recommendations by the health authorities to ensure the safety and wellbeing of employees and customers. Very few companies took the opportunity to provide information on the questions highlighted above and reassure bond holders that they have the means to ensure that they can honour their debt obligations including, where necessary, taking on additional bank facilities or government support that may be required.

For example, SD Finance plc correctly highlighted that “the Group has over the years built a strong balance sheet and cash reserves”. Also, Phoenicia Finance Company plc explicitly stated that it “fully expects to meet its payment obligations to its bondholders”. Moreover, Together Gaming Solutions plc pointed out that “even in the current circumstances, the company fully expects to meet its payment obligations to its bondholders” while Plaza Centres plc stated that it “is adequately capitalised and liquid to meet its financial obligations as they fall due”.

Apart from the inherent fundamentals of a company, the Government’s assistance to the business community through the moratoriums on business loans as well the Government guaranteed loans for businesses announced last week should assist those issuers or guarantors who require help in the circumstances to continue to honour their obligations to bondholders. Moreover, the improved measures announced on Tuesday evening as part of a social pact with the constituted bodies, should also result in reducing mass layoffs and business closures in the coming weeks. Various exponents in the media have been advocating for further bold moves prior to the additional measures announced on Tuesday evening given Malta’s strong finances with a debt to GDP ratio of only 43% with one columnist stating, “there is plenty of room for manoeuvre for the state to borrow on behalf of all of us and act as a guarantor”.

This pandemic is affecting all global economies. Malta is not alone so we must learn from what the larger countries are doing. As part of the measures announced by the German Government, an ‘economic stabilisation fund’ totalling €100 billion will be set up and will be used to take equity stakes in companies crippled by the fallout from the pandemic. Essentially, this would pave the way for radical state intervention. Moreover, last week, the French President openly declared that “no company, whatever its size, will face the risk of bankruptcy” as a result of the virus.

Significant assistance to the business community, however, is only one part of what is required for the Maltese capital markets.

The Government must also put into place certain mechanisms to ensure that it can provide liquidity to the capital markets in the same way that other authorities have done overseas. The Federal Reserve in the US launched a number of initiatives in recent days. Earlier this week, the Federal Reserve provided its full support to the economy by pledging to buy government bonds in unlimited amounts and also embarked on buying corporate debt for the first time ever. The purchase of corporate bonds will take place in two ways: (i) the Primary Market Corporate Credit Facility (PMCCF) backstops investment grade rated companies selling new bonds and (ii) the Secondary Market Corporate Credit Facility (SMCCF) will provide liquidity for corporate bonds traded on the market through a special purpose vehicle being set up via an equity investment from the US Treasury.

On its part, the European Central Bank increased its asset purchase programme by €750 billion last week through the Pandemic Emergency Purchase Programme covering both sovereign and corporate debt. However, it is not clear whether the Central Bank of Malta will be able to participate in this programme and acquire corporate bonds listed on the Regulated Main Market of the MSE.

As such, in view of the particular circumstances in Malta, the Government should also intervene in the market by setting up a vehicle to inject liquidity into the capital market. Since no bonds have an official credit rating in Malta, a number of credit metrics can be aggregated to form a risk scoring on which the investment parameters will be established. The provision of liquidity is also important to help Malta-based collective investment schemes that may be facing redemptions from retail investors and may need to liquidate certain holdings to meet such requests.

It does not take a huge amount of funds to try to restore confidence in the Maltese capital market and as measures are implemented, investors should respond positively and act in a more rational manner. As was evident during the global financial crisis that started in 2008, governments and central banks must act quickly, decisively and in a significant manner in order to convince markets and the investing community of their determination to counter the negative repercussions.

Failure to do so could lead to irreparable damage to the Maltese capital market also making it difficult for new issuers to raise funds in the future irrespective of an issuer’s financial strength and the nature of the industry in which it operates. Many market participants have been working very hard for several years to bring to life the local capital market and this is an important element of a modern economy. As the President of the ECB Christine Lagarde said last week: “extraordinary times require extraordinary action”. Let us learn from what the larger countries are doing in order to ensure that we emerge in a stronger manner and our economy and capital market do not remain crippled for many years to come. A co-ordinated emergency plan for the wider economy and also the capital market is required soonest.

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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.