CaiJin

Review of SGX's bond framework needed

Safeguards like a credit rating can be included to help retail investors recognise degree of risk involved

The carnage in the bond market has been confined to well-heeled investors up to now, even though the sums involved would almost certainly exceed the $520 million of toxic Lehman minibonds sold to the public eight years ago.

Some market pundits believe the fact that this financial catastrophe hasn't maimed a much bigger group of investors, as the Lehman debacle did, can be pinned down to pure luck.

Most bonds issued by companies are sold on the wholesale market, which is operated by a network of bank dealers, because they face less stringent requirements. Firms can issue a short information memo, for example, rather than a full-blown prospectus outlining their business. This has kept the bonds out of the reach of retail investors because buying even one lot could set you back by up to $250,000.

So when marine services firm Swiber collapsed under a mountain of debt three months ago, the fallout hurt mostly "accredited" investors - people whose personal assets exceed $2 million or whose income in the preceding 12 months was $300,000 or more.

To some, the timing of this calamity was fortuitous in a way because it might have prevented other financial catastrophes that could have ensnared retail investors as well.

How is that possible, given the obstacles, such as the huge capital outlay, an investor must overcome before he gets access to the wholesale market? The answer lies with an initiative taken by the Singapore Exchange (SGX) in May, after years of deliberation, to give companies the option of opening their bond issues to retail investors.

One obvious tweak to SGX's bond seasoning framework would be to remove the criterion that allows a company to re-tap the market for funds simply because it has issued at least $500 million of bonds in the previous five years, even if it has a market capitalisation of $1 billion or more.

Under the so-called bond seasoning framework, a company can offer new bonds to retail investors on the same terms offered to original buyers on the wholesale market after the bonds have been listed for at least six months. The sweetener for retail investors is that their outlay can be as little as $1,000, instead of the $250,000 forked out by investors in the wholesale bond market.

Companies, of course, get to raise even more money by issuing new bonds - but without the hassle of producing a full-blown prospectus, which is one reason they turn to the wholesale bond market in the first place. It is just as well that Swiber failed shortly after the bond framework was launched, but the episode has soured the appetite for high-yield corporate bonds.

The Swiber mess also enables us to re-examine the criteria laid down by SGX for companies that want to explore such an option to raise money. An issuer that wants to re-tap the market under the seasoning framework must meet at least one criterion in each of the three tests set by SGX:

•The firm must have a market capitalisation of at least $1 billion over the previous 180 days, or net assets of $500 million in the most recent audited financial statement as well as annual average net assets of at least $500 million in the three most recent audited financial statements;

•It must have a listing on SGX or another recognised stock exchange for at least five years, or listed bonds on SGX for at least five years; and

•It must not have recorded a net loss and must have a positive net operating cash flow for the three most recent audited annual financial statements, or it must have a credit rating of BBB or higher, or it must have listed at least $500 million worth of bonds in the previous five years.

As criteria go, the first two tests will ensure that only fairly large listed firms, worth $1 billion or more, are able to issue the same kind of bonds to retail investors that they sold earlier on the wholesale market.

While a company's size is no guarantee of the quality of its bonds, this criterion will at least filter out the small and risky bond issuers whose debts are likely to be thinly traded.

It is the third test that worries some analysts. Requiring a company to either register a positive cash flow or have an investment-grade credit rating of at least BBB in order to qualify is prudent. But if a company fails to meet either of these criteria, is it still okay to let the firm go ahead to "re-tap" retail investors for more funds if the firm has listed at least $500 million worth of bonds in the previous five years?

Some will argue that raising so much money selling bonds does not necessarily make a company a safer bond issuer.

To them, Swiber makes a good example. As recently as three years ago, it had a market capitalisation of over $1 billion. It had also been a very active seller of bonds on the wholesale market, with 20 issues under its belt. When it defaulted, bond holders were left with $551 million worth of worthless debts.

This leaves us to wonder whether it would have tried to use SGX's bond seasoning framework to raise money from retail investors if that mechanism had been available three years ago.

What should be done?

One obvious tweak to SGX's bond seasoning framework would be to remove the criterion that allows a company to re-tap the market for funds simply because it has issued at least $500 million of bonds in the previous five years, even if it has a market capitalisation of $1 billion or more.

Another obvious recommendation would be to make it compulsory for any company wanting to re-tap retail investors for funds to have a credit rating on the bonds - just to provide an additional safeguard.

One question often raised about retail investors is whether they even bother to look beyond the headline-grabbing yield offered by a bond before hitting the ATMs with their applications.

If a bond has a credit rating, this would at least ensure that retail investors can tell at a glance what sorts of risks they are taking, even if they do not take the trouble to study the financials of the bond issuer.

Given the low interest rates, retail investors sometimes take extraordinary risks to earn a higher return without realising the dangers they could be facing.

To its credit, SGX tries to mitigate the hazards by proposing a string of tests to try to protect their interests, before allowing new type of investments such as the bonds now traded on the wholesale market to be made available to them.

But, sometimes, Murphy's Law gets in the way - anything that can go wrong will go wrong. In that sense, we are lucky that SGX's bond seasoning framework hadn't been utilised yet when Swiber collapsed.

A version of this article appeared in the print edition of The Straits Times on October 17, 2016, with the headline 'Review of SGX's bond framework needed'. Print Edition | Subscribe