Paul Bonello, Wealth Manager
Sean Buttigieg, Investment Analyst
Purpose
Local corporate bonds lack an the internationally recognised credit rating. Such a CRA is probably too expensive for most issuers, albeit not for all. The Corinthia Group, for example, could easily afford the maintenance of a credit rating given its size and international spread.
In the absence of such credit ratings, there is a false tendency amongst local market participants to assume that the quality of the local bond issues is largely homogenous across the whole spectrum and deserving more or less of the same coupon rate. This market assumption is far from being the case. Such a false impression penalises the better-quality bonds and unduly awards the weaker ones.
The Finco Score is a quantitative and qualitative metric designed as a a tool to measure the risk inherent in a bond, and the resultant Risk-Reward Ratio, in the absence of a credit rating.
Applied to both existing as well as prospective debt securities
The Score is meant to be applied in the pre-issue phase when a prospective bond is being assessed with a view to determining whether to invest, and if yes, to what extent.
The Score is also applied to bonds post-issue with a view to continue tracking and monitoring their safety and to assist in a Buy, Hold or Sell decision.
The Score is applied to each individual debt instrument. If an issuer has several with different terms, there will be different Scores, one for each instrument.
Dynamic and updated in line with relevant events
The Score is meant to be dynamic, updated at least on the publication of the annual audited financial statements, but also re-calculated at any time on the occurrence of any relevant event.
Criteria
In the composition of the Score, 7 criteria are applied which collectively make up a 100. The Score is a measure of financial strength and credit quality. The criteria consist of a mixture of quantitative and qualitative factors, including relevant stock exchange ratios applicable to debt securities which best reflect the ability of the issuers to pay annual interest and eventual repayment of principal.
Assessment of liquidity of Issuer
This Score utilises the Current Ratio, that is the ratio between Current Assets and Current Liabilities. It measures the ease with which the issuer meets its liabilities as and when they fall due, including the annual interest payable to bondholders.
A weighting of up to 15% is allocated to this criterion.
The Median Score on the Official List – the number for which half of the listed companies are lower and half of the listed companies are higher – is approximately 1.20. This is interpreted as being rather low since the generally standard for the current ratio is appreciably higher, closer to 2.
A first assessment of gearing of issuing company: Total Debt compared to Tangible Assets
For the purpose of this ratio, intangible assets, such as deferred tax or goodwill arising on acquisitions, are excluded from consideration. These have no realisable value. In doing so, a considerable number of issuers end up in a net asset deficit, which means that there are no Shareholders’ Funds to support the company’s operations, which trading in effect continues courtesy of the financing being provided by the company’s creditors.
Amongst those with serious and staggering cases of an overall net tangible asset deficit are some rather large listed companies one would be surprised to discover.
This criterion carries a weighting of up to 12.5%. The highest score goes to the issuers whose such gearing is lower than 50%, which means that assets are financed in larger part by shareholders’ funds rather than debt.
The Median Score of this measure for listed companies on the main division covered by the Score is 67%, or a ratio of approximately €2 Debt for each €1 Own Capital.
It is worrying that there are companies where the debt is unacceptably high as indicated by several cases where the debt exceeds 200% of tangible assets.
A second measure of gearing: Total Debt as a multiple of EBITDA
This gearing ratio calculates how many years of operating cash flow – Earnings before Interest, Depreciation and Amortisation – will be required to repay total debt.
A weighting of up to 12.5% is allocated to this criterion, with points being allocated to how low (good) or how high (bad) the ratio works out at.
The Median Score for the Official List is 10.5. This means that half of the listed bonds have an even higher and worse ratio than 10.5, some indeed 15 and 20, which is of course incongruent with the fact that these bonds are supposed to be repaid after 10 years from operations, unless, as often happens, new debt is issued to roll-over old debt.
Interest Cover
This is calculated by the ratio of EBITDA over Interest payable of the Company.
This ratio measures the safety of margin of the payment of the annual interest afforded by EBITDA. A weighting of up to 15% is allocated to this criterion with the points being allocated according to how high (positive) or how low the ratio is.
The Median Score for listed company bonds covered by the Score is 2.47.
For some companies, the score is even negative.
Quality of Security
A weighting of up to 20% is attributed to this important component.
The factors considered in arriving at the score is not a simplistic enquiry as to whether the bond is denominated “secured” or not. It will consider more incisive matters such as:
i. Does the security consist of a charge on immovable property or a pledge over some readily realisable security?
A pledge on private company shares will be considered of little value, more so if the pledgee company is outside Malta.
Likewise, an unsupported guarantee is of little value unless it is issued by a guarantor of undoubted value.
ii. in the case of a special hypothec on an immovable, is the property situated in Malta or abroad, naturally with the former being preferred?
iii. is the hypothec a 1st ranking charge?
iv. is a first ranking general hypothec granted in order to guard the bondholders’ ranking amongst creditors in an eventual liquidation or in the event of the realisation of the security being insufficient for repayment?
v. have prior ranking general hypothecary creditors postponed their rights on the property being secured?
vi. is there a covenant prohibiting subsequent hypothecary charges on the immovable property?
vii. has the issuer procured a contractual renunciation by unpaid contractors of the right to register a special privilege in terms of the Civil Code?
viii. what is the open market valuation of the immovable and is there a sufficient margin to allow for accumulated interest and the event of a forced sale in case of foreclosure.
This must be seen together with an evaluation of the Negative Pledge covenant in the Prospectus. Most issues have so far allowed for only the value of the bond plus one year’s interest or similar by way of unencumbered assets. This margin of safety is far too low.
A desirable scenario would be one when the market valuation of the security property at the date of issue of the bond in its current physical state is 150% of the bond value.
xi. Is there a pledge on insurance over property in favour of the Security Trustee?
The size of the issuer
A weighting of up to 12.5%, depending on the size of the issuer, taking for this purpose the size of the Shareholders’ Funds (capital and reserves) less intangible assets.
The smaller the Issuer, the higher is the perceived and real risk of default of the bond involved.
The median for the bonds covered by the Score is €27.5 million. This indicates that half of the listed bond issuers are very small and have put in little capital.
Qualitative Assessment
This qualitative assessment consists of up to a 12.5% positive weighting as well as a negative weighting of 12.5%
The Positive Assessment will consider qualities such as:
- General reputation of issuer;
- Relevant behaviour of the issuer in relation to past relevant events, particularly the repayment of past issues of bonds without roll-over;
- Positive Governance, Risk and Compliance, and ESG Aspects;
- A corporate issuer where the majority or substantial shareholder is the Government.
The Negative Assessment penalises such matters as:
- an Auditor’s qualification of accounts or an emphasis of matter relating to the going concern assumption;
- a major event such as would have been COVID which affects the operations and the cash flow of the company, or litigation or threatened litigation such as currently with regards to Midi and Shoreline;
- Past relevant behaviour of the issuer or the occurrence of any event within the issuer’s control which failed the general expectations of investors. An example could be the case where a bond was not repaid on maturity but necessitated an extension of time. Or where the issuer attempted to change the terms of issue of an instrument to bondholders’ detriment.
- An assessment of the high risk or dubious social value of the business sector of the issuer such as high risk operations like offshore logistics in open seas, operations in third world countries, gaming industry, cannabis cultivation, crypto operations or other ethically controversial business.
Interpretation of Score
The higher the score, the better is the perceived quality and safety of the bond. Hence 0 is the most precarious, 100 being the best quality possible.
Any score below 40% presents substantial undesirable risks and financial weaknesses and increased possibility of default. Scores higher than 40% start becoming somehow acceptable especially if considered in moderate amounts.
Bond issues that score higher than 50% should be considered to meet the necessary safety criteria to safeguard investors, subject in any case to clients’ portfolios remaining sufficiently diversified. Scores higher than 70% represent the best quality issues.
The median of the bonds covered by the Score is 43.75 which means that less than half of the bonds in issue have acceptable risks for the retail investor.
16 bond issues score less than 30. There are presently only 13 issues that score more than 60 and 7 more than 70.
The coupon rate by way of pricing of risk
The coupon rate payable on the bond is not taken in consideration in arriving at the Score. The interest rate does not contribute to the safety or otherwise of the Bond but is merely the price for of risk, first amongst which credit risk.
The initial coupon on the primary market and the subsequent yield to maturity on the Secondary Market should then be assessed by the Investor against the Risk Score to consider the adequacy of the Risk / Reward Ratio of the bond being considered.
A general impression is that the spread over Government Debt for the relative term is low in the case of Maltese bonds, indicating a mispricing of the inherent risk involved.
The firm conclusion is that there is a general marked underpricing of risk and that coupon rates for Maltese bonds are pitched at a lower level than would be the case in the overseas open market for the same risk.