Sunday, 5 April 2020

Not All Hospitality Trusts Are Created Equal

In the past 2 months, investors have been selling off Hospitality Trusts (HTs) listed on SGX due to travel restrictions imposed by governments around the world to stem the spread of COVID-19. There are 6 HTs listed on SGX, namely:
  • Ascott Residence Trust
  • CDL HT
  • Eagle HT
  • Far East HT
  • Frasers HT
While all hotels will suffer revenue decline due to the travel restrictions, not all HTs will be impacted by the same extent. One important factor affecting the impact on HTs is their operating models. Traditionally, hotels have been owned and operated by the same party, but there are increasingly more investors who wish to invest in hotels but might not have the expertise or time to manage them. Thus, hotels might be owned by one party but operated by another, with revenue-sharing agreements between them. If you buy into HTs, you are buying into the ownership of the hotels. The operating model adopted by the HT will affect how the revenue and/or profit are shared between the owners (i.e. HTs) and the operators (i.e. hotel chains like Mariott, Hilton, Accor, etc.).

Some of the major operating models are as follow:
  • Owner Operated - The owner owns and operates the hotel, bears all costs and risks, and receives all profits. HTs usually do not adopt this model.
  • Master Lease - This is the simplest model when the owner and operator are different parties. The owner leases the hotel property to the operator in return for a fixed rental fee. The operator bears all costs and risks of operating the hotel. The owner does not have any share in the profits from operating the hotel. Nevertheless, there are variants to this model in which the rental can be variable and pegged to a percentage of the hotel revenue and/or profit. 
  • Management Contract - In this model, the owner engages the operator to run the hotel. The operator receives a management fee which is pegged to a percentage of the hotel revenue and profit. The owner bears all costs and risks of operating the hotel and receives all profits after deducting the costs and management fee to the operator.
  • Franchise - In this model, the owner runs the hotel using the franchisor's brand. The franchisor receives a franchise fee which is pegged to a percentage of the hotel revenue. The owner bears all costs and risks of operating the hotel and receives all profits after deducting the costs and franchise fee. A variant of this model is the owner outsources the operation of the hotel to an independent third-party operator. This arrangement is similar to a management contract, except that the third-party operator is not associated with the franchisor.
Fig. 1 below summarises the responsibilities of the owner and the operator/ franchisor in running the hotel.
Fig. 1: Various Hotel Operating Models

Needless to say, given the severe travel disruptions currently in place, the master lease model (especially the fixed rental model) would have the least impact to the revenue received by the HTs. Let us look at the operating model adopted by each of the HTs. Do note that a lot of these information are sourced from the annual reports. For HTs whose financial years end in Dec, the FY2018 annual reports are the latest ones available.


ARA US HT owns 41 hotels, of which 38 carry the brand of Hyatt and 3 carry the brand of Mariott. Fig. 2 below shows the operating model adopted.

Fig. 2: ARA HT's Operating Model

The figure shows that all of ARA US HT's hotels are franchised by Hyatt and Mariott and operated by independent third-party operators.

As explained in the section above, under the franchise model, all costs and risks are borne by ARA US HT, which is not a good thing during the current COVID-19 situation.

Ascott Residence Trust (ART)

ART owns 87 hotels and serviced residences. It recently merged with Ascendas HT to form the largest HT in Asia Pacific. ART adopts a combination of master leases and management contracts. Fig. 3 below shows the breakdown of gross profit from the various operating models in 4Q2019.

Fig. 3: Breakdown of ART's Gross Profit in 4Q2019

25% of the gross profit comes from master leases, while another 13% comes from management contracts with minimum guaranteed income.

Notwithstanding the above, there are fixed and variable rent components in the leases. ART disclosed that its operating lease receivable within 1 year of FY2018 is $70.3M. This is based on the fixed rent component in the leases. This amount represents only 14% of both the gross rental income and total revenue (rental and other income) in FY2018. In the worst case scenario whereby there is only fixed rental income, ART could see its revenue dropping by 86%.


CDL HT owns 16 hotels, 2 resorts and 1 retail mall across 8 countries. It has a combination of master leases, management contracts and owner-operated hotel. Fig. 4 below shows the operating model.

Fig. 4: CDL HT's Operating Model

Of the 19 properties, 13 are under master leases, 4 are under management contracts and 2 are owner-operated.

Although master leases form the majority of the hotels, they have fixed and variable rent components. Fig. 5 below compares the minimum and actual rental income received in FY2018.

Fig. 5: Minimum & Actual Rental Income for Master Leases

In total, the minimum rental income from all master-leased hotels forms only 49% of the actual rental income received in FY2018. As a percentage of total revenue, the minimum rental income constitutes only 35%. In the worst case scenario whereby there is only minimum rental income, CDL HT could see its revenue dropping by 65%.

Thus, although the majority of CDL HT's hotels are under master leases, the variable rent component in these master leases reduces the stability of income received by CDL HT in situations like COVID-19.

Eagle HT

Eagle HT was listed on SGX recently. It owns 18 hotels in US, most of which carry the brands of IHG, Mariott and Hilton. The operating model appears similar to that of ARA US HT, i.e. franchise model.

Far East HT

Far East HT owns 9 hotels and 4 serviced residences in Singapore. Fig. 6 below shows the operating model adopted.

Fig. 6: Far East HT's Operating Model

All their hotel and serviced residence properties are master leased to its sponsor, Far East Organisation and its related subsidiaries. Although Far East HT did not disclose the fixed and variable rent components of the master leases, it disclosed that its operating lease receivable within 1 year of FY2018 is $85.1M. This is based on the fixed rent in the master leases. This amount represents 93% of the rental income received from master leases and 75% of total revenue in FY2018. In the worst case scenario whereby there is only fixed rental income, Far East HT could see its revenue dropping by 25%.

Frasers HT

Frasers HT owns 9 hotels and 6 serviced residences in 6 countries. 14 of the properties are under master leases and 1 is under management contract. Like all HTs, the master leases have fixed and variable rent components. Fig. 7 below shows the minimum and actual rental income received in FY2019.

Fig. 7: Minimum & Actual Rental Income for Master Leases

In total, the minimum rental income forms only 49% of the rental income received from master leases and 38% of total revenue in FY2019. In the worst case scenario whereby there is only minimum rental income, revenue can fall by 62%.


The table below summarises the operating models adopted by the various HTs listed on SGX. For HTs with master leases, the table also shows the minimum rental income from master leases as a percentage of their total revenue.

Hospitality Trust Operating Models Min. Lease Rental
as % of Revenue
ARA US HT Franchises Not Applicable
ART Leases, Mgt Contracts 14%
CDL HT Leases, Mgt Contracts & Owner-Operated 35%
Eagle HT Franchises Not Applicable
Far East HT Leases 75%
Frasers HT Leases, Mgt Contracts 38%

Like most REITs, HTs have been well-liked by dividend investors. However, as this blog post shows, the revenue received by HTs is highly variable, depending on the operating model adopted. In theory, master leases provide the greatest stability compared to management contracts and franchises. However, most master leases of HTs have fixed and variable rent components. The higher the variable rent component, the more variable is the revenue stream. Dividend investors should really consider whether HTs should form part of their portfolios.

Although the segregation of roles and responsibilities between the owner (i.e. HT) and the operator through the various operating models splits the risks between them, it is ultimately a zero-sum game. When the hospitality industry faces a severe downturn like the current COVID-19 situation, neither the owner nor the operator wins. Even when the owner is relatively shielded at the expense of the operator via master leases with fixed rentals, investors need to check the credit risks of the operator. If the operator cannot pay the fixed rentals, the owner will also lose. Investors in hotel companies and HTs can only pray that the COVID-19 crisis is resolved quickly.

See related blog posts:

Sunday, 8 September 2019


How time flies. It has been exactly 7 years since I started this blog. It has not been a continuous process, though, as I stopped blogging for exactly a year from Jun last year to Jun this year. The cause? Burnout.

For 5 over years, I have tried to blog at least once a week. It gives readers continuity, as they know that I am always around. This is especially important during times of market stress, as readers know that I do not talk about investments only during good times and leave them in the lurch during bad times. Also, they only need to check my blog once and only once a week. The inspiration for a weekly blog came from a current affairs blog that I regularly visited in the past --, which is now no longer updated as the author has passed away. I liked the regularity of his week blog, which provided updates on a sufficiently regular basis but is not too frequent to follow. I thought too that I could achieve the same kind of regularity, but alas, trying to think up an idea, research about it, organise the thoughts and write it out, and then repeating the cycle 52 times a year proved too much to bear and I burned out.

It was not just blogging that I stopped. Almost everything connected to personal finance stopped. I stopped tracking my expenses, which I had done for the past 24 years. I also stopped monitoring the performance of my portfolio, which I had done for the past 20 years. Naturally, since I stopped blogging, I also stopped thinking about specific stocks and bonds.

During this 1-year hibernation, I wondered whether my blog has added clarity to investment issues or simply contributed to the noise. Individually, each blog might have very good reasons for their recommendations, but because different blogs have different opinions on even the same topic, to a person who is trying to search for some clarity on the internet, he might end up being more confused after reading these blogs than before he started. Nevertheless, my wife consoled me that I have done my best to value-add to the investing community. There will be some readers who would appreciate the unique opinions that I have.

Although I stopped thinking about specific stocks and bonds, I was still keeping up with financial news and there were issues that bothered me and made me want to blog about them. Such issues include the restructuring of Hyflux and DBS Vickers' plans to move the retail stock trading into the bank. Although upset, I did not have the time and energy to restart my blog. 

The issue that finally made me restart my blog was the IPO of Astrea V bonds in Jun. Coincidentally, my last posts before I stopped blogging were on the Astrea IV bonds. In my second-to-last post, I had blogged that I would not be applying for the Astrea IV bonds, although I corrected my initial thinking in my last post of 2018 and acknowledged that the Astrea IV bonds had sufficient safeguards. Fast forward to 1 year later, I decided to apply for the Astrea V bonds and I thought I should come out and reiterate my thoughts about the Astrea bonds before I applied for them. See Astrea V 3.85% Bonds – Understanding What You Are Buying Into for more info.

Once I restarted, the inertia was overcome and it became easier to continue blogging again. Nevertheless, I am conscious of the demands of a weekly blog and I would only be blogging whenever time permits and when ideas come to me. It is more sustainable this way. 

During the 1-year hibernation, although there were issues that made me want to restart blogging, there was also an incident that made me felt that all these years of blogging had been wasted. In Jan this year, I attended the Astrea Investor Day. During the Question & Answer session, one participant asked "could we have more of Astrea bonds?". This was despite the ongoing debacle of the Hyflux preference shares and perpetual capital securities. While I acknowledge that the Astrea bonds have safeguards to protect retail investors, I do not think that they are sure-win investments. Is it a case of the bonds having no risks at all, or that particular participant being blissfully ignorant of the risks? After coming back from hibernation, I wrote a series of posts on the Astrea/ Private Equity (PE) bonds. They can be found here. Readers can read and gauge for themselves whether the Astrea/ PE bonds are really risk-free or not.

That question really hurts. It hurts much more than if someone were to criticise my blog posts. For so many years, I have been blogging and keeping the blog free for all so that it could add value to the investment community and make a small difference to the world. That question just proved that it was probably my wishful thinking and my blog never really made much of a difference. It made me wonder whether I should still continue blogging. So, please, do not let me hear such questions again. It really hurts. 

Finally, for readers who have been regularly reading and supporting this blog, I thank all of you for your time and sharing of your views.

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Sunday, 18 August 2019

Possibly The Worst Time to Invest – 5 Years On

US-China trade wars, Hong Kong protests, US yield curve inversion, etc. You probably would be thinking now is a bad time to invest. I had the same feelings 5.5 years ago in Dec 2013, when the Dow Jones Industrial Average was then near an all-time high and interest rates near an all-time low. You can read more about it in Possibly The Worst Time to Invest. Nevertheless, I still went ahead to initiate a plain vanilla passive portfolio comprising 70% in global equities and 30% in global bonds. In 2015, I also added a more spicy passive portfolio comprising 70% in US equities and 30% in Asian bonds.

Each year, I would blog about whether that decision in Dec 2013 turned out to be correct or not. Each year, the blog post would say the passive portfolios were up and there is inherent defence mechanism to manage the fearsome stock market crashes through portfolio rebalancing. These once-a-year blog posts on this series almost sound like a broken record.

This year, the plain vanilla portfolio is up by 39.5% since inception 5.5 years ago, while the spicy portfolio is up by 34.7% since inception 4 years ago. You can read about last year's figures in Possibly The Worst Time to Invest – 4 Years On.

Each year, there are bound to be events that worry us and stop us from investing. But each year, the stock market would somehow manage to shrug off the worrisome events and continue its upwards march, reaching new highs which previously seemed unimaginable along the way. A couple of years later, would you still remember the events that stopped you from investing? Do you still remember the taper tantrum in 2013, the threat of Grexit and yuan devaluation in 2015, the shock Brexit vote and US presidential election in 2016? Some of these events have faded from memory, and some people might wonder what was the fuss that stopped anyone from investing in 2013/ 2015/ 2016, etc. But when these events were playing out, the mood was cautious and the stock markets were falling. A couple of years from now, would most people still remember the US-China trade wars, Hong Kong protests and US yield curve inversion that are causing the stock markets to drop currently?

There will be a time when the stock market crash really arrives. But no one can predict reliably when it will arrive. The best way to deal with it is not to stop investing, but to have a good defence mechanism in place while investing.

See related blog posts:

Monday, 12 August 2019

Effects of New Accounting Rule on Leases

Did you notice that in recent quarters, companies have been reporting better EBITDA (Earnings before Interest, Tax, Depreciation & Amortisation) and Free Cashflow figures? Do not be happy too soon, as the improvements could merely be due to a change in accounting rule for leases.

Before this year, companies that lease properties, equipment, etc. could choose to treat the leases as operating leases if they meet certain conditions and expense the rents as they fall due. There are no assets and liabilities on the balance sheet associated with these operating leases. This poses a problem when comparing against companies that own the properties and/or equipment. In reality, is a company that leases property very different from another that owns a leasehold property? In terms of the rights to use the property, the differences are small, but financially, the differences can be quite significant. On the balance sheet, such property-owning companies would have more assets and probably more loans to fund these assets. On the income statement, these companies would not have to pay any rent but would have higher depreciation and probably higher interest expenses.

Starting from this year, all companies have to adopt the Singapore Financial Reporting Standards (International) SFRS(I) 16 on Leases, which standardise the way companies report leases on their financial statements. Companies can no longer choose to treat their leases as operating leases and expense the rents. Companies have to treat their leases as financial leases and include the asset as a Right-of-Use (ROU) asset and a corresponding lease liability on the balance sheet. The lease liability is the present value of all future lease payments. At the start of the lease period, both the ROU asset and lease liability must match and balance out each other.

Companies only have the rights to use the ROU asset for the duration of the lease. Hence, at the end of the lease period, both the ROU asset and lease liability have to be reduced to zero. ROU asset is reduced to zero through depreciation. Lease liability is reduced to zero through amortisation. This is similar to loan repayment, in which the remaining loan amount each year is increased slightly by the interest expense, but reduced by a larger amount by the loan repayment. Both depreciation and amortisation affect the income and cashflow statements. It would be clearer to illustrate the changes using a company's actual financial statements.

The example used here is Hour Glass, which is a watch retailer that leases properties to operate its shops. Its business is generally stable, making year-to-year comparison valid. Furthermore, it separates out ROU assets and depreciation while most companies combine them with Property, Plant and Equipment (PPE), hence, allowing a clearer view of the effects of SFRS(I) 16. Companies should be encouraged to adopt the same practice.

Balance Sheet

Fig. 1 below shows the balance sheet for Hour Glass in 1Q2019.

Fig. 1: Balance Sheet

Hour Glass adopted SFRS(I) 16 starting from this Financial Year (FY), which began in Apr 2019. It added ROU assets of $113.8M and corresponding lease liabilities of $116.1M. The ROU assets are nearly twice as much as Property, Plant and Equipment (PPE) which amounts to $58.7M. This shows that the value of rental properties could be as much as or even more significant than the leasehold properties that the companies own. Note that not all companies report ROU assets separately; some companies report them together with PPE.

Income Statement

Fig. 2 below shows the income statement for 1Q2019.

Fig. 2: Balance Sheet

On the income statement, rental expenses are reduced significantly from $7.6M in 1Q2018 to $1.2M in 1Q2019. On the other hand, there is additional depreciation of $6.9M on the ROU assets. Finance cost is also higher by $0.5M to account for the interest expense incurred on the lease liabilities. Assuming all other factors remain constant, the net effect of these factors due to adoption of SFRS(I) 16 is a reduction of $1.1M in operating profit for Hour Glass in 1Q2019.

However, if you compute EBITDA, EBITDA computation excludes depreciation and interest, among others. Changes in depreciation and interest do not affect EBITDA. Hence, only the change in rental expenses affects EBITDA. Holding all other factors constant, EBITDA would have increased by $6.4M in 1Q2019. In 1Q2018, Hour Glass' EBITDA was $19.2M. The change in accounting rule for leases has increased Hour Glass' EBITDA by 33%!

Cashflow Statement

Fig. 3 below shows the cashflow statement for 1Q2019.

Fig. 3: Cashflow Statement

For Cashflow from Operations (CFO), depreciation from ROU assets is added back to the operating profit. For Cashflow from Financing (CFF), payment of lease liabilities, i.e. rental expenses, is included. 

Previously, rental expenses would have been deducted when computing the operating profit which is used as the starting point to compute the CFO. The rental expenses have been mostly replaced by depreciation of ROU assets, but in computing the CFO, the depreciation of ROU assets is added back. Hence, the net effect is an increase in CFO, by an amount equivalent to the payment of lease liabilities, which is now moved to CFF. Holding all other factors constant, the net effect is an increase in CFO by $6.1M, or 53% from 1Q2018!

Free Cashflow (FCF) is generally computed as CFO minus capex. Since CFO increased by $6.1M, FCF would have increased by an equivalent amount. Assuming no change in capex, FCF for Hour Glass in 1Q2019 would have increased by 68% simply from a change in accounting rule!


The above discussion summarises the key changes arising from the change in accounting rule for leases. There are other changes required to reconcile the balance sheet items for each company. For more details, readers are advised to read the companies' financial statments.

Also note that all the improvements in EBITDA and FCF compared to the previous FY mentioned above are also because companies do not have to restate the financial statements for the previous FY. Effectively, the financial statements for this FY are not comparable to that of the previous FY. Do not be too happy when you see an increase in EBITDA and FCF figures this year!

P.S. I am vested in Hour Glass.

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Sunday, 28 July 2019

Does SIA's 3.03% Bond Have Sufficient Margin of Safety?

Following up from last week's blog post on Will Temasek Bail Out SIA Bondholders In Event of Default?, here is the analysis on SIA's 5-year 3.03% bond based on Benjamin Graham's criteria as described in The Lost Art of Bond Investment. Surprisingly, the bond is not as strong as I initially thought based on a simple Debt-to-Equity ratio check. Below are the computation of the earnings coverage and stock value ratio based on SIA's latest financial statements for Financial Year 18/19 ending in Mar 2019.

Earnings Coverage
Profit before tax = $868.6M
Adjusted for:
- Deduct: Share of profits from joint ventures = $23.2M
- Add: Share of losses from associates = $97.4M
- Add: Rental on leased aircraft = $679.7M
- Add: Finance cost = $116.1M
Total earnings available for covering fixed charges = $1,738.6M

Current finance cost = $116.1M
Adjusted for:
- Add: Rental on leased aircraft = $679.7M
- Add: Interest for $600M @ 3.16% MTN 007 series = 3.16% x $600M

= $19.0M
- Add: Interest for $750M @ 3.03% MTN 001 series = 3.03% x $750M

= $22.7M
Total finance cost = $837.5M

Earning Coverage = $1,738.6M / $837.5M

= 2.08

Several adjustments were made to compute the total earnings available for covering fixed charges and total finance cost. The more unusual adjustment in SIA's case involves adding the rental of leased aircraft to both figures. This is because SIA leases aircraft in addition to buying them. The leases range from 6 to 12 years and cannot be cancelled, although there are options for early termination for up to 2 years before the original lease expiry. The leased aircraft do not appear on the balance sheet.

On the other hand, for aircraft that SIA owns by borrowing money from the banks, the aircraft appear as a asset and the loan appears as a liability on the balance sheet. On the income statement, there is no rental required, but SIA incurs depreciation and interest on the loan.

Hence, for the leased aircraft, even though SIA does not incur a finance cost, the rental is effectively a fixed charge that SIA has to cover, as the leases cannot be cancelled and SIA needs the aircraft to continue its operations. A similar adjustment needs to be made for the balance sheet, as discussed in the section later.

The current finance cost is also adjusted for interest on a $600M 3.16% Medium Term Note (MTN) issued on 26 Oct 2018 and the $750M 3.03% bond issued on 29 Mar 2019 which is the subject of this blog post. Although both bonds already appear on the balance sheet as at 31 Mar 2019, their first interest payments will only be made in FY19/20, Hence, their interest payments need to be added to compute the actual finance cost.

Based on the above adjusted figures, the earnings coverage is computed to be 2.08 times, which is below the minimum average earnings coverage of 3 times for industrial companies.

Stock Value Ratio

No. of shares = 1,199.9M
Share price = $9.62
Market value of shares = $11,542.6M

Current borrowings = $6,654.4M
Adjusted for:
- Add: Liability for rental aircraft = $2,200.0M
Total borrowings = $8,854.4M

Stock value ratio = $11,542.6M / $8,854.4M

= 1.30

As mentioned above, adjustments need to be made to the balance sheet for the rental aircraft. The rental aircraft is effectively an asset for SIA. Correspondingly, there should be a liability to account for the loan that SIA would have borrowed to purchase the aircraft outright. In fact, International Financial Reporting Standard (IFRS) 16 on Leases came into effective starting from Jan 2019 that requires companies like SIA to account for leased assets on their balance sheets. SIA has disclosed in its Annual Report that the assets will be increased by $1.7B while liabilities will be increased by $2.2B.

Considering the $2.2B increase in total borrowings, the stock value ratio is computed to be 1.30, which is higher than the minimum stock value ratio of 1.0 for industrial companies.

Quantitative Assessment

Thus, based on the above figures, SIA's 5-year 3.03% bond does not meet the earnings coverage criterion but meets the stock value ratio criterion. Based on Benjamin Graham's criteria, the bond does not have sufficient margin of safety.

Other Considerations

As mention in my blog post on Will Temasek Bail Out SIA Bondholders In Event of Default? last week, I believe Temasek will come to the rescue of SIA bondholders in the event that SIA could not pay interest and/or redeem the bond.

P.S. I am vested in SIA's 3.03% bond.

See related blog posts:

Sunday, 21 July 2019

Will Temasek Bail Out SIA Bondholders In Event of Default?

As regular readers would know, I stopped blogging for a year. I did not just stopped blogging; I also stopped monitoring performance of my portfolio and analysing shares and bonds in detail. So when SIA launched its retail 3.03% bond in Mar this year, I did not analyse it in detail as I would typically do using Benjamin Graham's method (see The Lost Art of Bond Investment for details) and simply bought it. I took a glance at its financial statements, carried out a simple Debt-to-Equity check and concluded that its debt obligations were not too excessive. Most importantly, I relied upon the assumption that SIA's parent, Temasek, would bail out bondholders in full in event of a default. This was not the only time that I relied on similar assumptions when buying bonds. I did the same when I bought Fraser Property's 3.65% bond (see Does FCL's 3.65% Bond Have Sufficient Margin of Safety? for more info).

Now that I am back to blogging (and thinking about financial issues), it is worth diving deeper to examine whether the assumption is rock solid and could be relied upon. Do note that this is not entirely a hypothetical question, as the airlines industry is a highly competitive one. Bankruptcies are not uncommon. Past examples include American Airlines, Delta Airways, Northwest Airlines, etc. going into Chapter 11 protection.

So, will Temasek come to the rescue of bondholders in the event SIA defaults on the bond? To answer this question, we need to first understand the background of SIA and Temasek. So, the first question is: will Temasek rescue SIA? The answer must be a resounding yes. SIA is the national airline and the pride of the nation. When our political leaders go overseas for conferences, they fly with SIA. It is difficult to imagine our political leaders flying on some other countries' national airlines. Thus, yes, Temasek will come to the rescue of SIA.

However, rescuing SIA the company is not the same as rescuing SIA bondholders. While SIA the company is a strategic national asset, SIA bondholders (and shareholders) are not. Furthermore, the ultimate shareholders of Temasek are Singaporeans. Bailing out SIA and its bondholders with Temasek's money is akin to using taxpayers' money to do so. It will be politically difficult to use taxpayers' money to bail out bondholders in full. The most likely scenario is that the settlement with bondholders will be at arm's length basis on normal commercial terms, i.e. the outcome would be similar to another company that is not owned by Temasek. In other words, bondholders will suffer some capital losses. This is not unlike the case of Hyflux preference shares and perpetual capital securities. Thus, from this perspective, SIA bondholders should not expect Temasek to bail them out in full.

On the other hand, SIA is not the only company that Temasek owns. Temasek owns a lot of companies in its portfolio. Temasek has triple-A ratings from both Moody's and S&P. Not all the companies in its portfolio has similar ratings based on their own merits. When companies with lower ratings borrow money, lenders take into consideration the fact that the company is majority owned by Temasek and offer a lower interest rate compared to a company that does not have Temasek as its backing. In the event that Temasek does not step in to bail out bondholders in full, credit markets will take note and will not offer lower interest rates to Temasek-owned companies in future. Each company has to pay an interest rate that is commensurate with its own credit rating. In other words, Temasek will have to bear higher interest payments across most of its subsidiaries. This long-term economic cost might outweigh the short-term political cost and prompt Temasek to bail out bondholders in its subsidiaries in full.

Finally, we should also note that Temasek, although it does not play an active role in day-to-day management of the subsidiaries' operations, is not a sleeping partner either. Long before trouble happens and hits the headlines, Temasek would have done something to avert it. For example, Tiger Airways, SIA's budget airline, had been losing money for 4 out of 6 years since its listing on SGX in Jan 2010. It carried out 3 rights issues over the same period. It also issued a 2% perpetual capital convertible securities (PCCS) in Apr 2013. If the trend were to continue, Tiger Airways would probably have failed and defaulted on the PCCS. In Nov 2015, SIA announced that it would take over Tiger Airways. It also redeemed all outstanding PCCS upon successful takeover of the company.

In conclusion, I had been lazy in analysing the SIA 3.03% bond when I bought it. But I guess I still can rely on the assumption that Temasek would step in and bail bondholders out in the event of default by SIA. Nevertheless, I should do my homework and analyse whether the SIA bond has sufficient margin of safety according to Benjamin Graham's method.

See related blog posts:

Sunday, 7 July 2019

Are Private Equity Bonds Better Than Corporate Bonds?

When Astrea V 3.85% bond was launched, some investors remarked that it is better than some of the recently issued corporate bonds, such as SIA 3.03% bonds. What are the differences between Private Equity (PE) bonds and corporate bonds, and are PE bonds really better than corporate bonds?

It is difficult to compare Astrea bonds with, say, SIA bonds, since their nature of business are different. To make the comparison between PE bonds and corporate bonds more meaningful, let us consider a hypothetical bond issued by Azalea Asset Management, which is the sponsor of the Astrea III/IV/V bonds. Fig. 1 below shows the corporate structure of Azalea.

Fig. 1: Azalea Corporate Structure

The assets of Azalea are the 3 Astrea companies issuing the Astrea III/IV/V bonds and owning the underlying portfolios of PE funds. Azalea probably has some other income-generating assets, such as the investment management company shown in Fig. 1 above, plus some other unlisted PE funds. Thus, the nature of business of Azalea and Astrea III/IV/V companies are similar. What would be the differences between the hypothetical Azalea corporate bond and Astrea III/IV/V PE bonds? Note that the PE bonds are not limited to the Class A-1 bonds which are open to retail investors. There are also Class A-2, B and C bonds.

The first key difference would be the security of the bonds over the assets. Astrea PE bonds are secured against the PE funds in the respective Astrea companies, whereas Azalea corporate bond would be unsecured. In the hypothetical scenario where the Astrea PE bonds default, Astrea bondholders could force the respective Astrea companies to liquidate their PE funds and return money to the bondholders. However, in the event that the liquidation proceeds are insufficient to redeem the bonds, bondholders have no recourse to Azalea, or to the other Astrea companies. For example, if Astrea III bonds were to default, Astrea III bondholders have no rights to the assets of Azalea, Astrea IV and Astrea V companies. The assets of each company are ring-fenced and could only be used to service the bonds issued by the respective company.

Similarly, in the hypothetical scenario where the Azalea corporate bond defaults, Azalea bondholders have no claims over the PE funds held in the 3 Astrea companies. Nevertheless, they could force Azalea to sell off the Astrea companies together with their portfolio of PE funds and PE bonds. However, they could not force Azalea to break up the Astrea companies, sell off their PE funds, redeem the Astrea PE bonds, and return excess cash to Azalea to pay off the corporate bondholders (Note: it might be possible to do so for other project/ asset-level bonds, but the terms of Astrea PE bonds do not allow for early liquidation of assets and redemption of bonds). In other words, regardless of what happens to Azalea, Astrea PE bondholders will not be affected. 

So does it mean that Astrea PE bonds, which are secured against the PE funds of the respective Astrea companies, are better than Azalea corporate bonds which are unsecured? Not necessarily. The key factor is the quality of the assets that are securing the bonds. If the assets are of high quality, the PE bonds have good collaterals. Conversely, if the assets are of low quality, the collaterals would be useless. Remember, Astrea PE bondholders have no recourse to Azalea and the other Astrea companies. They can only count on the assets in their respective Astrea companies to pay interest and redeem the bonds. 

Although Azalea corporate bond is unsecured, if the Astrea companies are generating good cashflows for Azalea, it does not matter whether the bond is secured or not. In a hypothetical scenario where one of the Astrea companies have poor assets whereas the other Astrea companies have good assets, it might be better to hold the unsecured Azalea corporate bond than the secured but troubled Astrea PE bond. So, quality of assets is key in determining whether secured or unsecured bonds are better.

The second difference is that Azalea could have other income-generating assets and businesses besides the 3 Astrea companies. In Fig. 1 above, it has an investment management subsidiary to manage the investments in PE funds for the Astrea companies in return for a fee. It could also have other PE funds that are outside the Astrea companies. So, for Azalea corporate bonds, there could be other sources of operating cashflows, whereas for Astrea PE bonds, the only source of cashflows is the PE funds in the respective Astrea companies.

The third difference is that besides receiving cashflows from the Astrea companies to redeem the Azalea corporate bond, Azalea could refinance the bond through bank borrowings, new corporate bonds, shareholder loans from Temasek, or even private share placements and IPO! Being a corporate bond, there are many avenues to refinance it. Astrea PE bonds do not have such avenues. To reiterate, Astrea PE bondholders can only count on the assets in the respective Astrea companies. If the assets are good, PE bondholders will get the promised returns. If the assets are poor, they will suffer some losses.

Having said the above, being able to borrow money is a double-edged sword. While borrowings could help to refinance the Azalea corporate bond, Azalea could also run the risk of borrowing too much money and jeopardise its ability to pay interest to and/or redeem the Azalea corporate bond if banks decide that Azalea's credit risk is too high. For the Astrea PE bonds, such risks have been mitigated. The terms of Astrea PE bonds prohibit the Astrea companies to borrow money other than to issue the different classes of bonds at inception, as well as to meet capital calls and cover bond interest payment shortfalls. The last 2 conditions are actually safeguards for the PE bondholders (see Understanding the Safeguards of Astrea IV 4.35% Bonds for more info).

In conclusion, PE bonds are not necessarily better or worse than corporate bonds. The key words are: quality of assets securing the PE bonds. This is unlike preference shares and perpetual capital securities, which are inherently inferior to stocks and bonds (see Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form for more info).

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