Retail Bonds: A Suitable Match for Mid-sized Corporates
There are several initiatives in Europe that facilitate bond issuance as a source of finance for mid-sized corporates with annual revenues of between €25m and €500m. Some initiatives have existed for a number of years in countries such as Italy and Belgium, but others have been initiated as a result of the 2008 financial crisis.
Banks are focusing internally on strengthening their balance sheets, due to incurred losses but also because of new regulations such as the Basel III capital adequacy regime. These circumstances have been the trigger for stock exchanges in several countries to develop platforms for trading relatively small bonds, initially for retail investors but now also for institutional investors although these bonds are still known as retail bonds.
The UK’s Order book for Retail Bonds (ORB) market and Germany’s Mittelstand (M)-bond market were both launched in 2010. In London, 36 bonds have been issued by 22 different issuers via ORB since then. Issue sizes have ranged between £20m to £300m, maturities from five years to 12 years and coupons have been in the range of 4.75%-6.25% or floating. Companies issuing in the ORB market are mainly well-known UK corporate names, such as Tesco, National Grid and three of the four main high street banks: Royal Bank of Scotland (RBS), Lloyds and Barclays. The size and names of these companies imply that they could also access the regular corporate bond market with institutional investors.
Retail bond issuance represents a new investor base but the downside is the heavy regulation as they have to comply with European Union (EU) rules, in particular the Prospectus Directive that establishes the framework for the preparation of a prospectus in public offers of securities.
The market in Germany is different from London’s ORB marketplace in that it mainly attracts small and mid-sized enterprises (SMEs). The first M-bond was introduced in 2010 at the Stuttgart exchange, Boerse Stuttgart – one of Germany’s local exchanges. M-bonds can now be traded at four other local exchanges in Germany: Düsseldorf, Frankfurt, Munich and Hamburg-Hannover.
M-bonds are bonds with principals typically between €10m and around €75m, although in exceptional cases that figure can be up to €100m. They are mostly issued by unlisted companies, which are relatively small compared with traditional bond issuing companies and with annual turnover of €26m to €400m. The volume of M-bond issuance currently stands at about €3.4bn and 70 different bonds have listed on local German exchanges since 2010. The market is still growing.
Pros
Companies that wish to enter the mid-sized bond market should be aware that bonds are a different type of funding to bank debt, which they usually use for external funding. Firstly, instead of just one party (the bank) needing information about the company, this has to be shared with potential investors in the market. This process is different and more formal, but also means that the company has to be more open. Family-run companies in particular might see this as a disadvantage, as they are normally less open both to the market and to their competitors.
Bond issuance gives the company wide exposure to the market. Initially marketing activities will support the bond issue process, but once the bond is listed the company name is visible on the financial markets. Although this is not the main purpose of the bond issue, it can be a bonus for the company to have this increased brand awareness.
Cons
The potential downside is that the company is in the public eye when times are hard, as well as when business is flourishing. Financials must be published on a regular basis, but also the price of the bond continues to be visible and reflects market sentiment for the company, which could translate into a negative effect on its brand and revenues.
In cases where the company is not able to meet its obligations to investors, the impact will be high and will cause it serious reputational damage. While bank debt issues can be kept between the company and the bank, issues with bond debt are open in the market. The first default in the German M-bond market, wind turbine maker SIAG Schaaf, occurred in April 2012 and two more companies have since filed for insolvency. Critics of M-bonds have warned of this potential risk in the past, although the three filed insolvencies to date appear not to have impacted the growth of the M-bond market.
Bonds are ‘bullet’ amounts, so there is no amortisation during the term. This makes the product more risky for the debt supplier then amortising bank debt. It also means that full redemption takes place at the end of the term. The company should consider how redemption can be achieved. If it does not have sufficient cash at that time, which is likely in many cases, new funding will be required.
The bond market for smaller bonds is a new market without a proven track record, so it is still uncertain whether it will remain liquid in the medium term. Banks have proven in the past that refinancing debt is common practice. Their commitment towards a company is much stronger than with bond buyers and it is in their own interest to support a company during the refinancing process. This makes bonds more risky for companies than bank debt and might even result in bankruptcy if they are not able to repay the principal amount and/or coupon payments.
My Word is My Bond
Bonds cannot easily be restructured. The amount, coupon and term are determined before issuance and cannot be changed during the term. Some prospectuses mention that the company has the right to repay the bond under certain circumstances, for example for tax reasons, or in the last year of the term.
Bank debt is often more flexible than bonds in this respect. Bank debt can exist in different forms and can be structured more in line with the debt requirement of the company, so taking into account seasonal patterns, flexible drawings (under a credit facility), etc.
Last but not least it is market practice – and for some exchanges a requirement – to require that the company obtains a credit rating. Getting a credit rating can be a costly exercise for corporates and can hold them back from going public. Alternatively, for example in Germany, local credit rating agencies certified by the Federal Financial Supervisory Authority (BaFin) are authorised to provide credit ratings for M-bonds and can do so at a lower cost than the well-known ratings agencies.
Credit rating is critical for investors in assessing the risk of a company. It saves a lot of due diligence for institutional investors, while retail investors will otherwise not be able to assess the level of risk posed by the investment.
Conclusion
Although there are many considerations to be made before a company can decide whether it is appropriate to issue in the bond market, it is likely to be used more by companies in the mid-sized arena. The retail bond market is a new source of funding for SMEs which, until very recently, were mainly funded by banks. Traditionally they relied heavily on the willingness of banks to provide finance, which often came only at a relatively high price.
Family-owned companies with high solvency ratios are therefore particularly suited to the bond market. Their motivation for entering the market lies in their desire for independence, to be free of bank interference and to retain ownership and control of the company.
Retail bonds offer an interesting proposition for companies in many European countries, where banks are facing issues with providing debt and where sovereign bonds have low returns and are no longer seen as a safe haven. The company’s success in accessing this funding source will depend on its financial strength, the appetite of retail investors and the availability of trading platforms. Furthermore, standardisation and controlled regulation will increase confidence levels for both the issuing company and investors.