Article by Maksym Skotarenko
The corporate bond market has become a crucial channel for raising capital in Malta. More than €3 billion is currently in issue across more than 70 issuers, giving local companies an alternative to bank credit, and savers one of the few routes to a return above a deposit rate. Interestingly, in more than 30 years, no bond on the Regulated Main Market has ever defaulted, or in other words failed to repay investors in full. Past performance is no guarantee of future outcomes, and that record should not be read as evidence that every bond is equally safe, nor that the decision comes down to picking the highest coupon at a preferred maturity. A prudent investor has several fundamental factors to consider before allocating savings to any instrument.
In foreign debt markets, an assigned credit rating from one of the major agencies such as S&P, Moody's or Fitch would do most of this work, condensing a full credit assessment into a single symbol backed by decades of default and recovery statistics. In Malta, credit ratings are limited to a single issuer, so investors must do their own analysis of the bond's prospectus, the Financial Analysis Summary and the audited accounts of the company.
The starting point is the company's ability to service its debt out of what it earns, in other words interest coverage. A simple method presents this as EBITDA divided by net finance costs. The weakness of that measure is that earnings are not the same as money available to bondholders, since the business must first spend what it takes to keep operating, whether that is refurbishing a hotel or replacing its fleet. It is therefore important to deduct maintenance and investment capital expenditures before judging coverage. A company covering interest three times on the headline measure may cover it barely once on an adjusted basis, which significantly alters the perceived level of credit risk posed by such a company.
Next, it is important for investors to check how much debt the company already has on its balance sheet. In other words, how leveraged is the issuer's profile? To assess this one would generally look at net debt to EBITDA, taken at the level of the group that generates the earnings rather than at the finance company that issued the bond, whose own accounts reflect nothing more than its role as a financing vehicle. It is worth reading this against the maturity profile, as four times leverage is a very different proposition when the debt is spread across a decade than when most of it falls due in a single year.
Investors should then look at the profitability of the company, its margins and operating income, which together determine whether a difficult year operationally turns into a missed coupon, and ultimately a default. One should establish how defensive each of the operating segments within the business is. A business operating at a 5% margin can absorb only a modest revenue shock before it stops breaking even, whilst one at 25% can potentially absorb a more severe one and still pay the interest on its debt comfortably. A trend of narrowing margins across the years shown in the Financial Analysis Summary should tell investors more than any single year's figure.
Beyond the financial ratios, investors should also establish whether the bond is secured, and by what underlying asset. The word "secured" appears in the title of many local issues, but it is not self-explanatory. One should assess which asset the security covers, when that asset was last valued, and whether any other lender ranks ahead of it. Where a bond is unsecured, the holder ranks behind every lender that does hold security over the group's assets. In theory, the coupon should compensate for that difference, but whether it compensates sufficiently is the investor's judgement to make.
None of the above can be read in isolation, as the same leverage levels, profitability margins or asset-backed security could mean different things depending on the underlying industry the business operates in. Property companies, for example, generally carry high leverage since the assets are long-lived and financeable, whilst non-cyclical businesses such as food or utilities can safely afford more leverage than their margins alone would suggest, because demand for their services is highly inelastic. Financials are different again, as leverage is the business model and net debt to EBITDA would not give investors that much colour. What matters there is capital, asset quality and funding.
All of this helps an investor judge how likely an issuer is to continue performing on its debt obligations. Whilst no defaults have occurred in Malta's corporate credit history, there is no guarantee that this status quo will persist indefinitely, and even a low probability event deserves some weight. Internationally, this question is addressed by the established credit rating agencies, which publish a credit rating measuring the likelihood of default alongside a recovery rating, estimating how much of a bond would actually be repaid if default did occur. In Malta there is no such assessment, and with no local default history to rely on, the estimate has to be built by asking what the company's assets would realise and in what order the claims against them are paid. That is a subject in its own right, and one worth exploring in greater detail.
Many local corporate bond issues are sound credits paying an attractive return. Having said that, investors should be prudent in evaluating each credit separately, scrutinising its qualities beyond a familiar local name and a headline coupon. This is the kind of assessment an investment professional is well placed to carry out, and to set against an investor's own financial goals and needs.
Maksym Skotarenko is Research Analyst and Portfolio Manager at Curmi & Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd, with registered address Finance House, Princess Elizabeth Street, Ta Xbiex, Malta XBX 1102, is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.