Bonds for Investors and Bond for Fantasy

The Times of Malta

The fashion is bonds.   With the equity market desperately searching for a solid bottom and with investors disgruntled with the equity performance of the last 2 years the attraction of fixed interest securities is understandable.

“Through disintermediation lenders and borrowers establish a direct relationship through the market cutting out the middleman’s (the bank) cost and keeping both sides happy”

Putting this in the context of falling interest rates forcing depositors to seek a better return from the low rates offered by Banks whilst still benefitting from 15% withholding tax arrangement and without exposing themselves to foreign currency risks, the market is definitely well served from the demand side.   There is huge demand for fixed interest high coupon securities which can provide an easy home for the savings of disgruntled depositors who are unhappy with the low rates that the banks can offer.

From the supply side, the corporate borrowers have noted this and are now approaching the market with notable frequency.   The motivations for the debt issuers are principally three:

1. The Banking system seems unwilling or unable to provide the long term finance on the terms they require and Banks seem more interested to get assets off their books to reduce their reserve requirements and instead invest in assets which demand much less administration and little or no reserve or capital requirements.

2. The Borrowers, even where the banks are willing to provide the finance, are interested more in the market funding in order to lock up their interest cost at current low level for a long term period.

3. Bonds allow borrowers much more lenient repayment arrangement as in many instances no sinking fund provisions are attached to the bond issues whereas the Banks would insist that borrowings are governed by regular instalment repayment plan.

This is a classic case of financial disintermediation where the orderly development of the capital market reduce the excessive reliance on the banking system for investment funding.   Through disintermediation lenders and borrowers establish a direct relationship through the market cutting out the middleman’s (the bank) cost and keeping both sides happy.  Lenders get a better return than they get from bank deposits whilst  borrowers obtain cheaper funding than the banks can supply.  

“Otherwise instead of a strong bond market we will have fantasy of the Bond type”

It looks like a solution made in heaven.   But is it?   The question is can the market remain orderly where the risk assessment and the risk pricing which hitherto used to be made by experienced intermediaries like the banks is now being thrown onto unsophisticated investors who are poorly equipped to price the credit risk and can easily be illusioned to part with their money with the glittering attraction of a high coupon rate?

Maltese investors have a poor record when it comes to risk assessment even where they have available the ready tools of credit rating by international rating agencies.   Their preference for international emerging market bonds and their exposure to defaulting Argentina bears witness to how easily the Maltese investors could be nudged not to look beyond the offer of a high coupon rate.

The Authorities, in permitting the issue of bonds without any attempt at their proper risk rating to guide the novice investor, are clearly permitting the gradual formation of an explosive situation which would ultimately damage the whole market and eventually close market access even to serious and respectful borrowers who deserve support and encouragement.

Without generalising we have had corporate bond issues that have not been properly priced to reflect the risk involved and that were undoubtedly bought by novice investors unaware of the financial risk to which they have committed their hard earned fortunes.

This worries me and should worry all serious market participants.   Consumers of financial services need to be spoon fed the risks attached to the products they are being offered and the Regulators should get out of their way to ensure that they do not simply  rely on authorised documentation which is too complex to be read by retail investors.    The need for credit rating of bonds to be issued for public subscription is urgent and necessary unless the market is to become the dump of borrowing proposals refused by the banking system.

Regulators, so meticulous in authorising advertising of products aimed for sophisticated investors, should be even more meticulous in licensing for distribution of products attractive to the novice or uneducated investor.

Otherwise instead of a strong bond market we will have fantasy of the Bond type.