Bonds: a popular but risky financing instrument

Recently, new bond offerings have been hitting the market almost every week. In many cases, the new bond issues are refinancing previous issues or additional placements when the first one failed to raise sufficient funds.

Bonds are becoming an increasingly popular financing instrument, targeting not only institutional investors but also the consumer retail market, but the latter are not always able to properly understand and assess investment risks. Increasingly, bonds are being offered to the general public, people who are not always able to properly assess the degree of risk and the purpose of the issue. A bond is essentially a loan with a fixed interest rate. Therefore, by investing, a person is effectively making a loan to the issuer - which means that he or she is taking on the risk of the creditor.

Despite its fancy name, a bond is simply a loan with a fixed interest rate. If the issuer fails to redeem the bond at maturity, the bondholders become creditors, whose order of claim depends on whether the bond was secured and what kind of security was provided. In essence, bonds create a loan relationship between the bond holder and the issuer. A decision to purchase bonds is therefore equivalent to a decision to grant a loan. In some cases, bonds distributed by the private sector are still equated with government securities, which are even safer than bank deposits and are more of a savings than an investment instrument. Buying private sector bonds is not saving but investing. Therefore, in order to assess the risk, the investor should understand to whom the loan is being lent, for what purpose and under what conditions the funds will be repaid.

The most common types of bonds offered on the market can be categorised according to listing and collateralisation criteria. Listed bonds are securities traded on stock exchanges. Listing bonds provide liquidity, as holders can sell their bonds at any time at the then current market price and thus recover at least part of their investment or even make a profit, depending solely on the market price of the bond. Unlisted bonds, on the other hand, do not have liquidity, so that the funds invested will, in principle, only be recovered at the end of the bond's term. Bonds are also divided into secured and unsecured. The key difference is that if the issuer is unable to redeem the bond, the proceeds from the realisation of the collateral (e.g. real estate, securities or other security) will be used to repurchase the secured bond.

In the case of unsecured bonds, if the issuer fails to redeem the bonds at maturity, the bondholders become third-ranking creditors, after mortgage creditors, the tax authorities and employees. This means that in the event of the issuer's insolvency, bondholders are unlikely to recover anything. In the event of an issuer's bankruptcy, unsecured bondholders are often left without any compensation. It is therefore necessary to look at what exactly the issue is secured by - whether it is a real asset or just a pledge of shares, which is often formal in nature.

What should be valued and understood?

For secured bonds, it is important to consider what is being pledged and the possibilities of recovery from the collateral. In some cases, existing or developing real estate is pledged - this type of collateral provides the greatest protection for bondholders and ensures that a larger part of the investment will be recovered, even in the event of failure. The situation is slightly different for bonds secured by a pledge of the issuer's shares. In some cases, the issuer does not carry out any activity itself, but lends the funds raised to the company developing the project. In other cases, the shares of the project company itself are pledged, but, as a rule, the assets of the project company are already pledged to the financial institution. Thus, in the event of failure, the result will be the same as with unsecured bonds. A security instrument only has real value if it can be effectively recovered. If the collateral is already encumbered by a bank mortgage, it often offers no real protection to bondholders.

Understanding that bonds are a risky investment, it is important to consider the purpose of the borrowing and the sources from which interest will be paid and the bonds repurchased. In some cases, bonds are used as bridge financing. For example, bonds may be used to finance the construction of a real estate project, with a view to mortgaging the property to a financial institution and then redeeming the bonds with the loan proceeds. In this case, the refinancing risk should be assessed. If bank financing is not forthcoming, e.g. due to insufficient cash flow, the issuer may have to issue a new issue. However, there is no guarantee that the market will accept it.

Alternatively, the bond proceeds can be used for construction work on a real estate project, and then the property is disposed of, with the proceeds used to redeem the bond. In any case, when valuing a bond, it is important to understand not only what the funds will be used for and how they will be repaid, but also how much equity is being invested in the project by the issuer or by its affiliates and controlling persons. The presence of equity indicates that the issuer has confidence in the success of the project. The higher the contribution, the stronger the incentive to maintain the project even in the event of a crisis.

Risk indicators: interest rate and reputation

Another important element that may be relevant for assessing bond risk is the reputation of the issuer and its affiliates and the financial capacity to provide additional capital in the event of a crisis.

The level of interest offered is also a key indicator of risk - the higher the interest, the higher the risk.

The proliferation of high-yield bonds suggests that cheaper financiers - banks, funds or crowdfunding platforms - have refused to lend because of excessive risk.A proposed interest rate of 15% or similar should be a clear warning. Cases such as Integre Trans or BigBrand have shown that even tempting return offers can result in investor losses.

In any case, bonds are a good and fast-growing financing tool, but like any other investment they come with risks. When deciding whether to invest in bonds, it is useful to rely not only on a colourful prospectus but also on the advice of professionals who understand the nature of these financial instruments. Bonds are not evil, but they are not a deposit either. It is lending, which always involves risk. Therefore, the most important thing is to understand what you are buying.

AVOCAD partner, lawyer Laurynas Staniulis