Each year, a growing number of investors are looking to invest in bonds and earn predictable returns. Bonds typically bear interest at a fixed or floating rate and have a specified maturity date on which they are redeemed. Investors therefore rely on receiving the expected return and repayment of their investment at the specified time. From a legal perspective, one point should be kept in mind: the higher the yield, the higher the corresponding risk. What, then, should investors consider when investing in bonds? Seniors Associate Krišjānis Bušs explains.
Bonds and Risks
Bonds are transferable debt securities issued by companies (issuers) and traded on stock exchanges. Bonds are issued pursuant to an offering document or prospectus, outlining the key information about the issuer and the terms of the bonds, including their maturity, coupon rate, early redemption conditions, financial covenants and other undertakings.
When investing in bonds, investors’ primary objective is to earn a return. At the same time, investors may have other objectives, such as supporting a particular company, contributing to the development of the local capital market or pursuing a particular investment strategy. As a result, investors’ decisions to invest in securities are often driven primarily by the coupon rate and the company’s brand recognition.
A high yield will usually reflect underlying legal or commercial considerations, which may correspondingly indicate a higher risk profile of the company. In such cases, investors should assess whether, and to what extent, the legal documentation governing the bonds provides for measures designed to mitigate those risks.
Key risks include, among others, the risk of insufficient cash flow and refinancing risk associated with the bonds (i.e., whether the issuer will have sufficient funds to repay the bonds at maturity or will be dependent on additional financing to fund their repayment), liquidity risk (i.e., whether the bonds can be sold on favourable terms in the secondary market), and risks relating to the issuer’s group (i.e., where the material assets are located, where the issuer itself sits within the group structure, who owns the assets provided as security, etc.).
Investors should also assess the issuer’s ability to comply with the undertakings and financial covenants set out in the terms and conditions of the bonds. A breach of such undertakings or financial covenants may constitute an event of default and require the issuer to repay the bonds before their scheduled maturity.
Security
Bonds may be either secured or unsecured. Companies within the issuer’s group may also provide corporate guarantees, under which they undertake to cover the issuer’s payment obligations in the event of a failure by the issuer to meet those obligations. The existence of security or a guarantee is an important risk-mitigating factor when investing in high-yield bonds, but does not always ensure that investors are fully protected.
Where bonds are secured, investors should therefore first assess the composition of the security. For example, the bonds may be secured by a commercial pledge over the issuer’s shares or assets, or by a mortgage over real estate owned by the issuer. In such cases, investors should assess the value of the collateral and understand how, and to what extent, the security may be enforced to satisfy the issuer’s payment obligations to investors.
For secured bonds, investors should also consider who holds the security and how, in practice, an event of default is announced and enforcement of the security is initiated. The security may be held by a collateral agent, in whose name the security interests are registered and who acts in the interests of all investors. A trustee may also be appointed alongside the collateral agent and authorised to represent bondholders in all matters relating to the bonds. Where a trustee has been appointed, the trustee performs the more complex technical functions on behalf of the bondholders, including giving notice of events of default and instructing the collateral agent to enforce the security. If no trustee has been appointed, the requisite majority bondholders must themselves be able to exercise their rights.
Therefore, when investing in bonds, investors should look beyond the coupon rate and the company’s brand and carefully consider the terms and conditions of the bonds. This enables investors to understand the risks underlying the bond yield and the potential consequences if those risks materialise.
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