Date: January 28, 2021
In this series’ earlier articles, we discussed the features of bonds and the benefits and risks. In a nutshell, although bonds are generally considered safer than stocks and offer a stream of regular interest payments, it is essential to bear in mind that all bonds carry risks, the only difference being the degree.
Government-issued bonds are considered risk-free in the country of issue, though there have been numerous occasions when governments have defaulted.
Corporate bonds range from those which are investment grade and are dependent on the rating agency classification. For example, investment grade bonds assigned “AAA” to “BBB-” ratings from Standard & Poor’s, and “Aaa” to “Baa3″ ratings from Moody’s. Lower ratings of bonds are referred to as “junk bonds”. However, credit ratings have their limitations and should not be your sole consideration when deciding whether a bond should be included in your investment portfolio.
The yield offered by safer, more stable companies will be relatively low whilst yields’ for junk bonds will be higher to compensate for the risk that the issuer cannot meet its obligations and might end up defaulting.
The question then arises: since the primary consideration in any bond issue is default risk, how can a prospective buyer accurately gauge this?
The simple answer is that every potential subscriber should read the issue prospectus because it contains all pertinent information. The problem is, as most investors would know, that this is not a realistic expectation because issue documents tend to be filled with dense, technical and legal jargon beyond the understanding of most laypersons.
Consider for example, that the Astrea IV Private Equity (PE) bond which pays a 4.35% coupon and matures on 14 June 2028 that was issued in 2018 to retail investors came with a prospectus that was 306 pages long, including Appendices. It would be doubtful that many who invested in these bonds would have taken the time to read through such a large document.
Do note that not all bonds are issued using a prospectus. Some bonds are issued using an Offering Circular, Offer Information Statement or Information Memorandum. For simplicity, in this article, we shall use the term prospectus to refer to the offer document.
The Product Highlights Sheet
To overcome this problem, the Monetary Authority of Singapore issued a Practice Note in 2018 which lays out guidelines on how bond issuers should frame their Product Highlights Sheet (PHS), which is a vastly condensed version of the prospectus.
These are the main features of the PHS:
- Submitted at the same time as lodgement of the prospectus;
- If the prospectus is posted online, the same has to be done for the PHS;
- Language has to be clear, simple and easily understood;
- Issuers have to avoid using legal, financial or technical jargon;
- If jargon is unavoidable, then issuers should attach a glossary to the PHS to explain the meanings;
- Key information should be disclosed in the PHS and issuers should not merely refer to information in other sources, such as the prospectus;
- Use of diagrams such as infographics, graphs, charts, flowcharts, tables or numerical explanations to explain structures or payoffs of the investment products to investors is encouraged.
The PHS is intended to give investors as broad an understanding of the bonds being offered as is possible in a few pages. It is possibly now the most commonly read document by investors during an issuance – certainly, they are more likely to concentrate on the PHS and rely on it to make their investment decisions than using the prospectus.
Gatefolds and/or Advertisements
Investors should also look out for other accompanying collaterals such as advertisements and gatefolds that provide information in a more layman manner.
For the Astrea IV PE bond, the issuer included an easy-to-read summary in front of their prospectus to aid the investor’s understanding. Informally known as a “gatefold”, it highlights key information such as the priority of payments, structural safeguards in place for investors and overview of the PE portfolio. The issuer also published advertisements in the local newspapers that contained highlights of the bond.
However, it is important to emphasise that having the PHS, gatefolds and/or advertisements does not mean the prospectus can be ignored. While lengthy, investors should take the time to understand the product and the risks associated with investing in it. The table of contents would be a useful navigation tool to direct an investor to the important sections.
Important to consider other factors
Prospective investors should have a good understanding of issuer’s business and gauge what the outlook is for that industry.
They should also go beyond the headline numbers, particularly if the coupon appears attractively large, and not part with their money unless they are fully satisfied that they know what they are buying as well as the associated risks and the conditions which could lead them to lose their investment.
If they are buying in the secondary market (i.e. after listing) they should evaluate other factors such as yield and liquidity. If the yield is high and liquidity is low, they should ask themselves why this is so and whether they are comfortable investing in such an instrument.
Just as important as all the above considerations, is to evaluate the outlook for the economy. If the forecast is weak, this raises the threat of default. A weak market outlook also suggests that interest rates could fall, in which case, the issuer might redeem the principal if the bonds come with such a call option. Investors should check whether the issuer has done this in the past because early redemption exposes bondholders to the risk of reinvesting their capital at lower interest rates.