Financial advisers appear to have a knowledge gap when it comes to corporate bonds, which are described by listed fixed income bond issuer Audacia Capital (Ireland) Plc as the life blood of businesses and economies the world over.
They often form significant portions of fund manager fund weightings, but advisers seem to lack a deeper understanding of how they really work and can be used.
Demand for high quality, ‘real’ asset-backed income bonds has never been higher or more relevant to investors, the Ireland-based firm writes.
We have seen the corporate bond market grew exponentially over the last three years, but the covid-19 market environment has compounded the growth and demand for these structures along with increasing the appetite of both businesses looking to use a bond to grow and investors looking for shorter term investments in a low-yield market environment.
Investors seem to be of the opinion that equity markets will be unreliable and unpredictable for the foreseeable future; this, coupled with the reluctance of banks to lend to businesses unless they are sizeable benchmark deals in the hundreds of millions, means there is a real need in the economy to supply efficient corporate finance benefitting both obligors and investors.
Back to basics
All businesses need capital and even the largest corporations and governments borrow rather than tie up cash or dilute equity.
Bonds are essentially IOUs, with an obligor (borrower) agreeing to repay investors (lenders) at the end of a set term, with an agreed rate of interest (the coupon).
The quality of the bond will depend on a number of factors, one of the biggest being what is the actual security being pledged.
For many, a mortgage will be the biggest loan of our lifetimes and this is extremely similar to a corporate bond arrangement – a bank will lend a sum to allow us to buy our house, with an undertaking (a bond) from us as the borrower to repay the borrowing and to pay interest along the way.
As part of this bond; the lender will take a charge over our house and, in the event we don’t pay our mortgage or default on the loan, the lender can take our house – this is the security. There are also other ways such as getting a cash-out refinance loan.
Beware unlisted offerings
With a corporate bond, investors and their advisers should research and undertake due diligence on what the security being pledged actually amounts to.
Sadly, there are a few high-profile instances of mini-bonds and loan notes that have been marketed over the last few years where no tangible security was ever really present (despite the claims).
Plus; the bonds were unlisted, which means that they did not have to undergo the scrutiny of a regulated stock exchange to verify the information being stated by the borrowing company.
Additionally, an unlisted bond has no demonstrable means of controlling how borrowed funds are used – there is no accountability, transparency and the borrowing business can use the funds for any purpose, which in a few cases has been for the benefit of the owners lifestyles rather than the stated purpose.
First things first
This, of course, is not every case and large numbers of ‘proper’ bonds are issued on major exchanges every month.
So, with the number of bonds available, with a wide range of coupon rates and maturity dates, what should investors and their advisers be looking for?
The bond should be listed on a major recognised stock exchange.
Those listed on smaller exchanges are often unacceptable to retail investors as they provide no liquidity and no prospect of a secondary market.
This makes the investment highly illiquid and smaller exchanges are only really suitable for institutional investors and high net worth investors who can accept the prospect of losses.
For smaller private investors, advisers should only recommend bonds listed on the main liquid exchanges where there are significant trading volumes and secondary markets; such as London, Dublin or Luxembourg.
Do the maths
Advisers and investors should research what liquidity is on offer by either the issuer or the borrower.
Bonds are generally not redeemable before the end of their term, but if the issuer or borrower maintains liquidity then an early exit may be possible.
At Audacia, for example, we as issuer retain 8% cash in trustee maintained segregated bank accounts on every bond we issue to provide some degree of liquidity for investors.
Do the simple maths – if the bond is offering a coupon of 10% and paying the adviser a commission, then the underlying business needs to be generating 10% plus that commission amount to break even simply on repaying the bond and that’s without accounting for all the expenses of running the business.
We have seen bonds with 15% coupons offering 20% commissions on the market – this means the business needs to be generating 35% without accounting for any other expenses of the running the business, paying staff, directors etc.
While not always the case, most businesses cannot sustain this and this presents a higher risk of the bond failing.
Is the borrower company a ‘pass-through’ SPV (special purpose vehicle) that has been set up to use investors’ money, or is the borrower a long-standing, established business that is the direct obligor?
Check the money flow – ensure the funds are being lent directly to the business being described as the obligor.
The latter scenario will generally be able to show the investor a track record, will have audited accounts and tangible assets directly pledged as security.
A pass through SPV will be a separate legal entity, which often means it has been set up to circumvent a lot of the diligence and to separate out the assets of the “real” business giving little or no recourse to investors.
Is there a security trustee?
An independent security trustee will allow the investor to have recourse in some way over the assets of the obligor should the business underlying the bond fail.
A security trustee will have the ability to take over the assets of the business, appoint an administrator to liquidate the assets and then, as trustee, oversee the distribution of the proceeds to investors.
At Audacia, we use DMS Governance Limited on every bond we issue.
DMS is regulated and independent and ensures that funds are used for the purpose they were meant to be used for; and, in the event that the business does fail, it can step in and undertake the process of distributing assets.
We hear and see the term ‘asset backed’ all the time but it means nothing if the assets are not ‘real assets’ or are not sufficient to cover the borrowing.
Investors and their advisers should know and be able to see verification of what the security being pledged actually is.
A bond for a car maker, for example, is likely to have a factory with machinery such as cast technologies machining shop, finished cars as stock, spare parts and spare part sales, an order book with deposits, and probably a brand IP.
The total of these assets could equal tens of millions, which gives investors real recourse in the event the bond fails.
Similarly, bonds for mining companies, infrastructure, or property, (provided the money is being lent directly to the business and not a separate SPV) will generally give real assets and give investors recourse.
If the bond has been listed properly then the issuer and the exchange it is being listed on will have seen the asset valuations, historic audits and accounts, and have been able to assess the likelihood of successful repayment (much in the same way as your bank assesses you for a mortgage).
On the other hand, bonds investing in something ‘not yet built’, gambling or trading programmes, or esoteric ideas are not likely to have any real value or assets if they go wrong; so, while they state they are asset backed, its meaningless if the assets have no real worth.
Making it mainstream
Bonds are sometimes called exotic or alternative investments – why?
They play a vital role in all economies and nearly all portfolio managers, fund managers, and DFM’s will use fixed income bonds in their portfolios.
In this time of highly volatile equity markets, the weighting of the majority of managed investments will have shifted more into corporate bonds.
Bonds should form part of most investors’ portfolios.
As with any investment, provided the proper research and diligence has been undertaken and the risks assessed in line with the investors risk appetite, then there are a good number of well-structured, robust, listed, rated bonds with real assets backing them that give yields above the equity markets and without the volatility.
This article was written for International Adviser by Audacia Capital (Ireland) Plc.