Process flow of issuing a bond - what to look out for and key risk areas

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Below is a simple presentation of what to do and what to focus on at the various stages of the bond issuance process. Full details on the various stages can be found in previous postings such as:

The Flow of a Bond Issuance - Part 1 - Pre-issuance stage

The Flow of a Bond Issuance - Part 2 - Primary Level

The Flow of a Bond Issuance - Part 2 - Primary Level (continuation)

The Flow of a Bond Issuance - Part 2 - Primary Level - Users of FAST

The Flow of a Bond Issuance - Part 2 - Primary Level - Primary Trading Process and Procedures

The Flow of a Bond Issuance - Part 3 - Secondary Level - Trading process and market conventions

 

Process Flow of the Bond Issuance Process

Bond Defaults - Rights of Bondholders

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In theory:

•Unsecured bondholders:

–Ranked parri-passu with all other unsecured creditors

•Secured bondholders:

–Rights to the assets secured to the bondholders

•Subordinated bondholders:

–Ranked lower than the unsecured creditors

In Practice: There are a few loop holes that bondholders can exploit. This is especially so with bonds that was issued when then the market initially boomed. As time progresses, lessons learned from previous defaults have been incorporated into the latest legal documents so as not to provide the legal means to do something that goes again the original understanding.

Bond Type: Exchangeable Bonds

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This kind of bonds is a relatively new concept whereby issuers will exchange the bonds with shares from another company. An example is the Berjaya Holdings which issued exchangeable bonds to be exchanged for Berjaya Sports Toto shares.

The motivation behind issuing such a facility is to piggy-back on the share price performance of the other company. If planned correctly, issuer need not pay back the bonds as bond holders will see better value in exchanging it into shares than redeeming it at nominal or face value.

The risks to both issuers as well as the bond holders are as follows:

1.For the issuer, it must have the shares in the target company before issuing such a bond.

 

2.Issuer may dilute its holdings in the target company is bond holders exercise their rights to exchange. 

 

3.As the reference asset is not the issuer, the issuer may not have control over the whole life of the bonds.

 

4.Due to the convertibility factor, an overestimation of the company’s share price performance may caused the investors to overpay for the bonds.

 

5.The volatility of the equity markets can caused similar volatility in the shares of the bonds.

Bond Type: Convertible Bonds

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Issuers which listed shares can issue convertible bonds. The motivation behind issuing such a facility is to piggy-back on the share price performance of the issuer. If planned correctly, issuer need not pay back the bonds as bond holders will see better value in converting it into shares than redeeming it at nominal or face value.

The risks to both issuers as well as the bond holders are as follows:

1.For the issuer, there is a very strong possibility of share dilution. There is an opportunity for new shareholders to enter the company.

 

2.Due to the convertibility factor, an overestimation of the company’s share price performance may caused the investors to overpay for the bonds.

 

3.The volatility of the equity markets can caused similar volatility in the shares of the bonds. Generally, the volatility of bond market is less than the equity market (hence the lower returns).

Bond Type: Subordinated Bonds

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Issuers can issue bonds with varying degree of subordination. Unlike the junior/senior bond structure which is a split from a bond programme, subordinated bonds are stand-alone programme.

In the Malaysian context, banks are the most prolific issuers of subordinated bonds. This is because due to the Basel capital requirements for banks, subordinated bonds can be recognised as quasi-capital.

Because the subordination can be done at anytime, it is possible for issuers to have multiple bond issues with varying degrees of subordinations i.e. The most subordinated will take the first loss for the rest, the second most subordinated will take the next loss for next set of subordinated bond above it etc.   

In reality, investors are not keen to participant in bonds issued by such issuers as their priority may just change with a new issuance.

Bond Type: Commercial Paper versus Medium Term Notes

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Commercial Papers (CP) and Medium Term Notes (MTN) are bond that is different in terms of tenure. Generally, CPs are short-term bonds that have maturity of less than 1 year whereas MTNs are long-term bonds that have maturity of 1 year of more.

In terms of ratings, due to the peculiarity of the tenure classes, the way credit risk is assessed is different with different rating scales.  Generally, the purpose of the two types of structures are as follows:

1.CP: usually used for short-term cash flow management purposes.

2.MTN: usually used for mid- to long-term capital investments

Risks:

 

1.Issuers using CPs to finance mid- to long-term capital investments can face liquidity issues if no investors wants to rollover a CP programme upon maturity.

 

2.Moreover, the cost of a CP programme cannot be locked. Re-pricing will happen upon rollover.

Bond Type: Junior versus Senior Bonds

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•Purpose: to apportioned more credit risk to the junior piece

•Method: creating an internal credit enhancement

•Effect: reducing costs

By splitting a bond into two tranches, a junior bond with higher credit risk and a senior bonds with a lower credit risk, the issuer is able to offer the necessary risk reward payoffs to two sets of distinct investors. The first, which is risk adverse and the other who is risk preferring.  The design of such structuring is an internal credit enhancement and therefore offers the least costs to the issuer.

The risk reward payoff to the investors are as follows:

1.Junior bond holders usually get a higher coupon. However, in event of difficulties, they may not be paid even if the senior bond holders get paid i.e. they take first loss.

2.If the senior bond holders get paid but not the junior bond holders, generally it is do deemed as an event of default.

Collateralized Debt Obligations

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CDOs are a type of structured ABS whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association, a savings institution that later became insolvent. A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market.

The issuer of the CDO, typically a bank, earns a commission at time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating and securitizing loans, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality.

CDO is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follow:

Source of funds

•Cash flow versus Market Value CDOs

–Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDO's assets. Cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio.

–Market value CDOs attempt to enhance investor returns through the more frequent trading and profitable sale of collateral assets. The CDO asset manager seeks to realise capital gains on the assets in the CDO's portfolio. There is greater focus on the changes in market value of the CDO's assets. Market value CDOs are longer-established, but less common than cash flow CDOs.

Motivation

•Arbitrage versus Balance Sheet CDOs

–Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. The majority, 86%, of CDOs are arbitrage-motivated.

–Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A bank may wish to offload the credit risk in order to reduce its balance sheet's credit risk.

Funding

•Cash versus synthetic CDOs

–Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. The risk of loss on the assets is divided among tranches in reverse order of seniority.

–Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swaps, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss on a specific asset in the event that asset experiences a default or other credit event.) Like a cash CDO, the risk of loss on the CDO's portfolio is divided into tranches. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche receives a periodic payment (the swap premium), with the junior tranches offering higher premiums.

–Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional assets. A portion of the proceeds from the funded tranches is invested in cash assets and the remainder is held in reserve to cover payments that may be required under the credit default swaps. The CDO receives payments from three sources: the return from the cash assets, the reserve account investments, and the CDS premiums.

Key Concepts in Securitisation & its Benefits

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True Sale Criteria:

•Any transfer of assets by the originator to an SPV must comply with the true sale criteria

•The underlying assets must be isolated form the originator – even in receivership or bankruptcy situations

•The originator must transfer all rights and obligations in the underlying assets to the SPV

•The originator must not hold any equity stake, directly or indirectly, in an SPV

•The SPV must not have any recourse to the originator for losses arising from the assets apart for any credit enhancement provided by the originator at the start of the securitisation transaction

Special Purpose Vehicle:

•An SPV must have independent directors or trustees

•It must be bankruptcy remote

•It is responsible to ensure that its assets are managed properly and in the best interest of the bond holders

•The SPV and the bonds issued must not carry the same name as the originator or be similarly identified with the same

•It must maintain proper accounts and records to enable complete and accurate view of its balance sheets as well as its income statements

•It must comply with all regulatory reporting requirements

Benefits of ABS

Originator

•Additional source of cheaper funding 

•Reduce asset/liability mismatch 

•Monetised illiquid assets 

•Locking in profits 

•Transfer risks 

•Off-balance sheet  

Investor

•Portfolio diversification

•High quality asset

•Not exposed to the credit risk of the originators

•Potential higher rate of returns

Introduction to Securitisation

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Securitisation is a financial technique of pooling various categories of assets and creating securities in order to represent an aggregated and pooled assets.

These assets are usually homogeneous with relatively same characteristics.

The assets are legally isolated from the source so that the securities will not affected by the financial performance of the originator. 

The value of the securities comes for the pool of assets and its related income stream.

As it is legally a stand-alone structure, investors rights are only to the pooled asset.

Key definitions:

Asset backed securities (ABS):

Bonds that are issues pursuant to a securitisation transaction. Such bonds shall exclude bonds that are capable of being converted into equity. Examples of such excluded bonds include exchangeable bonds and bonds with attached warrants.

  

Securitisation transaction:

An arrangement that involves the transfer of assets or risks to a third party where such transfer is funded by an issuance of bonds. Payments to investors are derived directly or indirectly form the cash flows of the assets.