We have previously published articles explaining the particular things to look for in both an individual bond and 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 OMNI Bridgeway bonds (formerly IMF Bentham) to highlight some of the events that can occur over the life of a bond. This bond was called in mid-2022 but still remains among the best examples we can find of a bond that had the majority of events that can possibly happen to a bond over its life, so we will still use it as a demonstration case.
The chart below is a graphical representation of how these events played out through the lens of the (indicative mid-market1) price of the bond and shows how underlying conditions or events influence the performance of the particular bond.
1. Primary issue
OMNI Bridgeway, listed on the ASX as OBL, began life as IMF Bentham. One of a few global specialist litigation funders, OMNI (simplistically) lends to law firms to finance large law cases, typically class actions. In recent times, their business model has moved away from deploying their own funds from their balance sheet, to managing funds invested by others (and co-investing in those funds).
With the increasing likelihood that they would be involved in actions against major banks, and to avoid the conflict of interest in having funding from a potential defendant in a case, IMF Bentham took the proactive step of further diversifying their funding sources, which included a listed bond, by issuing an OTC bond in April 2016.
Given the unavailability of bank finance considering the sector the company operates in, a bond is an excellent way for IMF to fund itself for a longer term than bank finance, and also remove the uncertainty that would be placed on its prior funding had they initiated an action against their own bank.
Raising $32m at a 4-year fixed rate of 7.40%, this bond looked attractive with an initial credit margin of approximately 5.10% over a 4-year base swap rate of 2.30%.
This attractive margin proved enticing in the secondary market post-issuance and allied to a scarcity of bonds with the credit strength of OMNI, the price rallied after the issue as has often been seen with FIIG-arranged issuance.
Due to growth in demand for funding and opportunities identified by the company, IMF came back to investors less than a year after the primary issue for further funds, looking to increase the size of the initial issue on the same terms.
Having performed well in the period since the issue, investors were happy to lend further funds to IMF. Being more familiar with the credit after nearly a year of updates, investors upsized by a further $40m at a price of 101, reflecting the now more familiar issuer’s credit profile.
The yield to the now 3-year maturity at this price was 7.04%, which reflected a credit margin of approximately 4.90% over the 3-year swap rate.
3. Retail availability
When first issued, bonds are available only to wholesale qualified investors. Typically, after 12 months from issue, they are “seasoned” and become available to retail investors. Given the tap above, this was delayed from the first issue as the clock was restarted when the tap was done.
Therefore, in April 2018, retail investors began to buy the bond. As is expected when new buyers for a limited supply of a resource are added at the margin, the price usually rises in response. Retail investors typically have fewer options available to them in the bond market as many issuers place a wholesale-only restriction in the issuing documentation, and so may have the appetite for lower yields.
One further point to consider is that one of the reasons for the seasoning period is to ensure any issues with the bond are worked out in the first 12 months. As this period, particularly for a first-time issuer, contains more risk, it should be expected that investors who take this risk should be compensated with a higher yield. This ‘new issue concession’ – the incentive to draw buyers to a new bond rather than others that are available in the secondary market – is realised by the investors at primary issue.
So, in summary, as the date approaches when the bond may qualify for retail investors (noting this does not always happen), price appreciation is often observed.
4. Early Call
As mentioned previously, pre-determined early call dates are put into the bond documentation, allowing the issuer flexibility to manage their debt profile if situations change. Typically, investors are compensated for this removal of an income stream by a capital price higher than the par issue price.
This becomes a consideration for investors in the secondary market, as they need to be aware of the price paid relative to potential future calls which may be at a lower price than that at purchase.
The concept of Yield to Worst takes this into account and shows investors the worst yield they can expect if a particular call is exercised.
In this case, the call date was the 30th of June 2019 at a price of 101. Knowing that this was a possibility, as time proceeded towards this call date, the price of the bond declined from highs of around 104 in mid-2018 toward the call level.
After the call had passed, the next scheduled redemption was the maturity date on the 30th of June 2020. With the restriction of the 2019 call having passed and the short time to maturity, the price of the bond was freed and rose once again.
5. Refinance – consent and exchange
As mentioned above, OMNI transformed their business over the life of the bond from largely investing in cases directly from their own balance sheet and taking principal risk on the outcomes of cases, to taking outside investors into managed funds in which they co-invest and earning management fees.
As a result, its earnings are more stable and more diversified – both of which are good for the credit risk of lenders.
Recognising that over the term of the first bond to date base market interest rates had declined significantly from approx. 2.50% in 2016 to approx. 1.25% in late 2019, OMNI looked to refinance the original bond into a new, longer bond with a lower coupon.
To do this they required the consent of the bondholders, as the pre-determined call date when they had the opportunity to redeem the bonds had passed, and as such, holders needed to agree to a change in terms to allow a redemption earlier than the final maturity.
The offer was to repay the existing bond at a premium to par of 101, reflecting the following considerations:
- The previous call price of 101
- the fact that the new bond, proposed to allow existing wholesale holders of the old bond to ‘roll over’ into it, carried a lower coupon of 5.65% fixed for a longer 7-year term
- Existing holders would be denied the higher coupon for the remaining term to maturity.
The new coupon of 5.65% fixed for 7 years represented a credit margin of approx. 4.40%, which was seen as a fair margin – still for an unrated credit – but reflected the improvement in OMNI’s credit profile and the longer tenor than the initial bond.
Investors voted in favour of the exchange and as a result, the old bond was redeemed at 101 on the 20th of December 2019 and the new one was issued to wholesale investors only (as for all new issues) at par on the 8th of January 2020.
With the uncertainty of the refinance out of the way, the bond was recognized as having a good long-term credit profile and the price once again appreciated, free from near-term call restrictions.
6. 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. OMNI 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 OMNI, fell dramatically.
However, OMNI’s business was largely unaffected by the lockdowns and restrictions that were placed on the general populace. As time moved along, investors realised that OMNI represented a good risk/reward given the new outlook, and the price recovered quickly.
With interest rates also having been cut aggressively by the RBA, the price of the OMNI bond recovered to trade at levels above those seen since the first COVID-19 impact.
We said at the time:
Where the future takes the price of the OMNI 5.65% 2026 bond is uncertain, as it is with all investments. However, it seems likely that with an improved credit profile, a business model resilient to shocks, and a scarcity of similar investments, there is potential for the bond price to climb once more and provide an excellent risk-adjusted return for investors.
7. Recovery and subsequent early call
The recovery from the COVID shock, as we all know, was swift as rates were taken to and held just above zero.
Recognising the quality of the credit and its resilient business model, the price appreciated again to well above par. Not having upcoming calls (due to the relatively new, longer maturity), the price was again freed to trade to a level that represented the market level demanded the risk, which resulted in a price of around 104.
Towards the end of 2021 and in the first half of 2022, it became clear to the market that inflation was appearing as a result of the huge amounts of easy money and liquidity thrown at the global population during the pandemic, and not reined in early enough.
As a response, market interest rates began rising, and fixed rate bond prices began to turn downwards.
In early May 2022, OMNI informed the ASX that they had arranged a large bank facility, enabling them to repay all outstanding debt obligations as well as to provide further funds for growth. As a result, the bond was called early in July 2022 at a price of 102.
Over the life of the bond, assuming an investment at the original primary issue and holding to the eventual final redemption, it has delivered investors a return of approx. 7.06% per annum, which, considering the absolute level of interest rates over the period was very low, is an outstanding result.
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.