We have previously published articles explaining the particular things to look for in both an individual bond and also the issuer of a bond, when evaluating an investment.
It is important to consider these criteria before buying a bond, but events during the life of a bond can give the investor a chance to re-evaluate the position, and make sure that the original thesis for investment still holds.
Bonds can have a number of pre-determined milestones built into the documentation which are important for investors to consider, such as early calls, but there are also other events that can make changes to the way investors view a bond.
We shall use the example of the ZIP Money Trust 2017-1 B bond to highlight some of the events that can occur over the life of a bond. Whilst there is the year 2017 in the name of the bond, the relationship with Zip as an issuer is still current via a
number of refinancings and new bond issues as we discuss below.
The chart below is a graphical representation of how these events played out through the lens of the (indicative mid-market1) price of the bonds and show how underlying conditions or events influence the performance of the particular bond.
1. Primary issue
Back in 2017, the fintech and Buy-Now-Pay-Later phenomenon was starting to get mainstream traction, with the two main players being Afterpay and Zip.
Zip’s founders had more of a traditional finance background than Afterpay and set up their business slightly differently with a more traditional base, which led them to access the capital markets to fund their growth.
They first issued a bond arranged by FIIG from a receivables trust in 2017. Receivables trusts are a well-known and standard financing method for all sorts of lending businesses, the best known probably being Residential Mortgage-Backed Securities for
home loans.
Raising $40m for a 2-year revolving period with a minimum credit enhancement of 7.7% and at a floating rate of 1M BBSW +6.00%, this bond looked attractive with the high initial credit margin providing a forecast yield of approx. 7.80%.
This attractive margin proved enticing in the secondary market post issuance and as a short dated high margin floating rate note (of which there aren’t ever many particularly in this kind of size), the price rallied after issue as has often been
seen with FIIG-arranged issuance.
2. First exchange and refinance
As the initial 2-year period came to a close, the bond trended in price back to par in anticipation of repayment.
Zip requested investors roll the bond for a further 2 years as well as adding a further $20m of capacity to the B note tranche in this particular warehouse, for a total of $60m of drawn funds. A majority of current investors remained invested in the bond,
with many adding more capital as well as new investors participating.
As the receivables in the Trust had performed as expected over the initial term, the margin on the new Notes remained at 6.00% for a forecast yield of approx. 7.20%. The minimum credit enhancement was lowered to 6.0% from 7.7%, but as the Trust was larger,
more diversified and had a longer history to enable more accurate forecasting, this was deemed acceptable by investors who fully subscribed to the upsized amount.
With a further 2 years to run, the price could again appreciate as it was not constrained by an imminent maturity price of par (100).
3. COVID impact and volatility
As we all know, the impact of COVID became apparent towards the end of February 2020 and markets suffered large falls in a short period of time.
Zip did not escape this fate as investors required much higher yields given the huge amount of uncertainty over the virus outcome, and the price of higher risk bonds, i.e. those with lower ratings or unrated such as Zip, fell dramatically as credit spreads
widened to account for the increased risk.
Over the course of the next year as conditions stabilised and as the bond again approached its 2-year scheduled maturity, the price recovered sharply towards par.
A coupon margin of 6.00% at a time when base interest rates were anchored just above zero proved a great asset for the bond, providing investors with a strong income stream at a time of low returns.
4. Second exchange and refinance
The recovery from the COVID shock, as we all know, was swift as rates were taken to and held just above zero.
In the intervening period since the first refinancing of the bond, Zip has established a Master Trust where the vast majority of the receivables generated by their business were now held.
This reduced their need for funding via the Zip Money Trust, and accordingly the size of the bond was reduced in line with the smaller overall size of the warehouse to a $30m offering.
Credit enhancement remained at a solid 6% but recognising the further improved history and low loss record of the pool, the margin on the Notes was reduced to 5.25% as the facility was extended for a further 2-year period.
Base rates were essentially zero, so a margin of 5.25% was attractive and the price opened above par and remained there for a long time.
5. Poor company performance drives jitters in the bond
For lower or unrated bonds, performance of the company is a larger driver of their bond prices than the underlying base rates in the market.
As part of the continuing global expansion of the business, particularly into the US, and with the arrival into the BNPL space of major global players, the share price of the listed Zip entity took a major hit with continued losses being reported.
One of the key features of a receivables trust is that they are bankruptcy remote structures from the originating entity, and as such the issues facing the profitability of Zip itself had no fundamental impact on the performance of the receivables in
the Trust, which continued to behave as expected.
However, some investors grew nervous and decided to exit the bond, which pushed the price lower. For other investors who were willing to look though the publicity as a related but essentially immaterial issue for the Trust, a bargain was to be had.
The public markets were continuing to support the issuance of other notes backed by the Master Trust, and as such we had confidence that our Trust would be able to continue performing.
We said at the time:
As further described in this note, we remain comfortable with the performance of the various Zip Co warehouses. While performance has been deteriorating since the start of 2022, it is from a very low base and the transactions continue to perform well within expectations (against parameters or the lack of adverse rating actions).
Unlike the share price which reflects future profitability, the performance of the warehouses on the other hand is tied to the quality of the underlying assets / receivables.
6. Recovery and eventual repayment
In May 2023, as the bond approached the scheduled maturity date, it became clear that Zip would repay the bond, and the uncertainty surrounding the future dissipated.
The bond was redeemed as expected on the 19th of May 2023.
However, that wasn’t the end for the FIIG/ZIP relationship.
A further bond issuance, comprising 2 tranches of a new structure, this time issued from the Master Trust was arranged by FIIG and issued on the 19th of December 2022.
These bonds have performed as expected and have actually been called early and are due to be repaid in the next week at a premium, at the call price of 100.50, returning investors 14.8% and 22.2% annualised.
7. Conclusion
Many events over the life of a bond influence the price and the appetite of investors to either buy, hold or sell the bond.
Some of these are discussed above and provide investors with checkpoints to ensure the original thesis still holds, and then to take action or not.
Understanding the fundamental credit risk of lower or unrated bonds is critical to these decisions as we have outlined above.
1 Note this is not a price at which bonds may be bought or sold, but is the indicative ‘fair value’ price in the middle of the bid and offer prices at which bonds were sold and bought respectively