Follow us

Bonds - new market challenges and investor protection

Recently, there has been a trend towards using bonds as a new tool to raise finance. However, in many cases, investors, perhaps due to lack of experience or a reluctance to understand the situation, do not appreciate the true risks of investing in the bonds being offered. Laurynas Staniulis, Managing Partner of AVOCAD, talks more about this.

First of all, it should be understood that a bond is simply a debt security issued by a company or government. It is a document that gives the bondholder the right to call on the entity that issued the bond at the end of the bond period. The entity that issued the bond is obliged to repay the money invested. In other words, the bondholder and the issuing entity have an elementary loan relationship.

Today, we see a trend towards bonds with very high yields and relatively short duration. In fact, borrowing at such a price means that, for one reason or another, traditional means of financing, such as loans from financial institutions or investment funds, are not available. The reasons for this may be varied, but the fact remains that probably no entity will borrow at 15% when banks are lending at an average interest rate of 8-10%.

Also, looking at the current trend in bonds, we see that the bonds that are being distributed are generally not secured by collateralised real estate, but rather by a pledge of the shares of the company that issued the bond as collateral. In terms of whether such collateral provides real protection, one would have to say probably not. Since, if shares are pledged, it is likely that the issuer does not have any assets pledged or that those assets are already pledged. This means that if the worst case scenario does occur and the entity is unable to redeem the bonds, the claims of the bondholders would only be met after the claims of the mortgage lender have been met, and only then, if there is anything left over, would it be the bondholders. I would therefore probably not be very far wrong in saying that such bonds are, in essence, simply a loan without any additional security for the bondholder.

Another point to note is that bonds are often placed to refinance an existing bond issue, while the source of redemption of the new bond is a future planned bond issue. This pattern of short-term high-yield bonds implies that the bonds are not issued to finance a new activity that would directly result in a redemption source, but rather to temporarily balance cash flows, to build equity or the like.  

However, from today's perspective, can we say that when the bonds mature, the issuer will have the ability to refinance them and, if necessary, service even more expensive bonds? Probably not, which leads to the view that the bonds issued simply reflect the issuers' belief in a positive market development. But the "what if" question remains unanswered.

Sometimes the answer to this question can be deduced, albeit indirectly, from the assessment of the issuer. If the issuer is a project company that is part of a large group of companies, and the bonds are not redeemed by the "parent" company, we may consider that the "parent" company is aware of the risks of the project and is not prepared to fulfil its obligations to the bondholders at any cost. Obviously, this is only an assumption and one would like to believe that if the issuer is unable to meet its obligations, there would be a consolidation of the Group's forces to redeem the bonds. However, the reluctance to formally commit leaves the question open.

In summary, bonds are not a new way of raising funds and are certainly not a threat in themselves. Bonds, like any other investment, involve risks that each investor has to assess individually according to his or her risk appetite. However, in any case, investing in bonds should not only be based on a careful assessment of the issuer or the collateral, but also on an understanding of the objectives of the bond.