The local bond market has lately been encountering some considerable turbulence. Various listed bond issues are on the radar as to possible difficulties, nay default, in the redemption payment on maturity.
This unfortunate situation has been long in coming but this was to be expected, and indeed prevented, by the financial policymakers and regulator.
It is too defeatist to adopt the recent stance of the Finance Minister Clyde Caruana and say that some defaults are inevitable. Nor is it the simplistic explanation of a stockbroker that eventual defaults are the result of the strong growth of the bond market.
A considerable number of local bond issues have been the easy way out of issuers’ inability to make sound bankable proposals to the commercial banks.
Often, the bond market is tapped when the banks are unwilling to accommodate the issuer, or to fend off pressure from banks to refinance existing bank borrowing. There is an undesirable motive for tapping the local bond market because it is far less demanding than the savvy bankers and bond issuers can get away with much more favourable terms on the shallow sophistication of the bond market.
The result has been that – contrary to the general belief of local retail investors – many local bond issues are unduly risky, most often due to the inadequate capital put in by the issuer and the consequent high gearing. The result is that often these bonds are redeemed on maturity with fresh issues such that these fresh issues would consist of new debt to repay an old one.
What is even worse is that so-called “secured bonds” are almost invariably defective in the way the security is concluded, as compared to borrowing from commercial banks.
This phenomenon has been possible because the local retail market consists in a very large majority of financially lay people, predominantly retirees and pensioners, only interested in the higher coupon obtainable on local bonds when compared to bank deposits and safer debt securities, and which interest can help them supplement their social security pensions and maintain a better standard of living.
And this segment of the investing population is liquid rich, a fund which local issuers have not taken long to realise its potential especially considering that they easily glitter for gold, oblivious to the underlying inherent risks.
Furthermore, during the process of the vetting of bond issues by the Listing Authority, the latter is bombarded by the potential issuer together with an army of accountants, auditors, financial advisors, stockbrokers and law firms, if not also some political pressure, all bearing pressure to obtain sanction of the least arduous terms of issue for their debt on the market.
There is no one tasked with the duty of safeguarding the interests of the investors and the role of “advocate” for the financial consumer other than the Listing Authority, left to itself.
The security trustee, if there is one, has no mandate to negotiate the terms of issue on behalf of the potential investors and is powerless to demand better safeguards in the interest of the investing public. Any such attempt by the security trustee would lead to him being immediately replaced by a tame and friendly competitor security trustee.
This article presents proposals for the longer-term stability of our capital markets, ensuring that local bond issues are of better quality and provide more peace of mind to the retail market investors. Our bond issues should not consist of failed candidates for medium to long-term financing from banks but issues that inspire faith and stand on their own feet in a competitive market for finance.
Proposal 1: Standard conditions for a “secured” bond issue
Bonds denominated as “secured” give the strong impression to the retail investors that the risk of default in such bonds is minimal. Hence, it is imperative that public policy ensures that the investing public is not mislead and given false hopes of low risk.
An unsecured bond supported by strong company financials is preferable to a secured bond of a precarious issuer.
Many so-called secured bonds are so termed because there is some sort of fixed charge on immovable property. Therefore, in the case of “secured bonds”, the security should be required to be perfected to a standard which in banking circles constitutes “extendible security”. It should be perfected on conditions similar to what a commercial bank would demand. Many readers have passed through the gruelling experience of obtaining an ordinary house mortgage, let alone business finance in millions.
Therefore, it should bea condition that a fixed charge on an immovable (special hypothec) is first ranking and is also accompanied by a first ranking general charge (general hypothec) to ensure adequate protection in case of ranking in liquidation for any portion of the bond not covered by the liquidation of the security.
Further subsequent charges in favour of third parties on the hypothecated property securing the bonds should be contractually prohibited.
There should also be the condition that the issuer procures a contractual undertaking with building contractors that the latter renounce to their right to a special privilege in terms of law for unpaid works as otherwise these would rank ahead of the bondholders supposedly secured by a special hypothec.
The hypothecated property should be adequately insured with adequate pledge in favour of the Security Trustee.
Above all, the market value of the hypothecated property – valued by architects of the issuer’s choice – should no longer cover merely the face value of the bond plus one year’s interest but should have a margin of safety closer to 50%, again similar to banking practice. Indeed, if the security were to be realised, the price obtainable is likely to be that in a forced sale and would not fetch the price otherwise obtainable in an arms’ length open market, in addition to the possibility that the property may have been over-valued in the first place.
We have had cases of “secured bonds” where the security consisted of a pledge of private company shares, indeed even in a foreign jurisdiction. Such security is nothing other than a poison pill for investors should they be in a position where they have to consider realising the security, considering the usual pre-emption and other restrictions on transfer of shares and the incidence of legal costs abroad. An attempt to realise the pledge and take over the management is an assured nightmare.
Proposal 2: Ensure that the bond issue is applied for the ostensible use of funds
With anecdotal tales of cases of application of bond proceeds for other than their ostensible purpose, it is proposed that the Listing Authority makes it obligatory that the Prospectus obliges the issuer to appoint a Security Trustee – even in circumstances where the issue is unsecured – for the Trustee to have the responsibility of effecting payments in line with Prospectus’ use of funds. Change of use during the term of the bond – as indeed has happened – must not be allowed.
Proposal 3: Banning public issues of bonds not listed on the MSE
There have been cases of public issues of bonds in the local market which are not listed on the Malta Stock Exchange.
Even listed bonds suffer from insufficient liquidity – ease of sale and purchase on the market – let alone unlisted bonds. A holder of such bonds wanting to dispose of his holding can only do so through the issuer at a price set by the issuer itself.
The incentive for the issuer in such cases is the saving of issue costs and perhaps less regulation. For the investor, there are only adverse implications.
The absence of Listing Rules renders an investment in such unlisted bonds a voyage in uncharted territories.
Unlisted bonds are manifestly not safe for retail investors, especially in a market like ours where financial literacy is close to zilch.
In similar past issues, unlisted bonds issues were still oversubscribed by the public, notwithstanding the risk warnings in the prospectus. Perhaps they were misled even more because, although unlisted, the MSE will still have been appointed as registrar of the bond.
The MFSA, as the national competent authority, should utilise the product intervention powers contemplated by the EU MiFID Directive (and sister MiFIR Regulation) whereby the regulator has the power to prohibit the issue of a particular financial instrument that is considered detrimental to the retail investing public.
Proposal 4: Proper transposition of the EU rules for subordinated bonds
The local market is aflush with subordinated bonds issued by banks.
Subordinated bonds are issued by banks because they qualify as a type of capital and therefore reduce the need for the issue of more equity to comply with increasingly tough regulatory capital ratios meant to avoid state bail-outs as in the last big financial crisis of 2008. In this way, banks avoid diluting the ordinary shareholders.
On the other hand, subordinated bondholders assume big risks in the event that the bank encounters financial problems. A “resolution and recovery” situation may evolve that would entail either the subordinated holders having their bonds cancelled or else converted to equity.
The banks issuing the subordinated bonds are amongst the most enthusiastic pushers of these bonds in selling them to their own clients, a practice known as self-placement.
Retail investors typically rush into subordinated bonds because these issues pay a slightly higher interest rate than ordinary bonds.
There have been many casualties of this type of debt security in Europe, most notably in Italy, Portugal and Spain. Most occurred in the first decade of this millennium when quite a handful of banks failed – including the oldest established bank, Monte dei Paschi di Siena – and hundreds of thousands of pensioners became penniless.
To avoid this happening, an EU Directive introduced safeguards in January 2021 by what is known as Article 44a of the BRRD II covering bail-inable bonds and subordinated bonds. These safeguards consisted of various restrictions on the sale of such bonds. Some measures were mandatory, and some others were optional for each Member State to decide upon.
The measures implemented in Malta include the requirement of a Suitability Test for the subscription of subordinated bonds. In other words, it made the abuse of Execution-Only instructions not possible.
Another measure put in place is the requirement that the initial investment amount invested is at least €10,000, leaving the option for member states to raise it to a minimum of €50,000. The rationale is to weed out those with the smallest capital available for investing and who would be ready to rush in for the additional small coupon. Malta has opted for the minimum amount.
The most important safeguard, however, was a requirement that where subordinated bonds are sold to a retail client whose overall bank deposits and investment portfolio is smaller than €500,000, investment firms must ensure that the retail client does not invest an aggregate amount exceeding 10% of that client’s liquid funds and portfolio, taking into account any previous subordinated bonds the client already holds.
Paul Bonello.However, this latter requirement was optional for Member States whose banking sector size does not exceed €50 billion. The Maltese regulatory authorities did not apply this requirement.
In not implementing this requirement, it is my opinion that MFSA has failed the financial consumers they are primarily meant to protect in terms of the statutory objectives specified in Article 4 of the MFSA Act.
I have long argued for the immediate implementation of this measure, whereby there would be a limit to how much a retail investor can expose himself to subordinated bonds. We need to protect financially illiterate consumers from themselves and from the human innate greed. Especially so because of the risk of self-placement by banks issuing such subordinated bonds.
We must not allow a casualty to occur before implementing this sensible measure.
Paul Bonello is Managing Director of Finco Treasury Management Ltd but is writing this opinion piece strictly in his personal capacity.