Would I Invest in Astrea IV 4.35% Bonds?
- Original Post from (The) Boring Investor

Recently, Temasek launched a Private Equity (PE) bond for retail investors known as Astrea IV 4.35% bond. It is the first PE bond open to retail investors. Would I invest my money in this bond?



First of all, let us understand what this bond is all about. This bond is issued by Astrea IV Pte Ltd, an indirect wholly owned subsidiary of Temasek, to hold a portfolio of PE investments. The investments are managed by 27 General Partners in 36 PE funds and invested in 596 companies. 86.1% of these funds are invested in buyouts, with 12.3% in growth equity and 1.6% in private debt.



Buyout funds are funds that privatise publicly listed companies, cut the excesses in the companies and streamline their operations to make them more efficient, and seek to exit the companies by selling them or listing them again. An example is Amtek Engineering, which was delisted from SGX in 2007 after being bought out by a PE fund, and was relisted as Interplex Holdings in 2010. And the story did not end there. Interplex Holdings itself was delisted in 2016 after being bought out by another PE fund.



The issuer, Astrea IV, has 3 classes of bonds, as follow:



  • Class A-1 - SGD242M 4.35% senior bonds that are open to retail investors and which are the subject of this post.

  • Class A-2 - USD210M senior bonds open only to Institutional and/or Accredited Investors. Class A-2 bonds have the same seniority as Class A-1 bonds.

  • Class B - USD110M bonds junior bonds open only toInstitutional and/orAccredited Investors.



The structure of the bonds is such that Class A bonds have priority to interest payments and bond redemption. In addition, it can borrow money from banks to make interest payments in the event that there are insufficient cashflows to do so. Moreover, its Loan-to-Value (LTV) ratio is capped at 50% of the portfolio value. If this threshold is crossed, it will have to cut debt levels. Furthermore, Class A bonds are senior to Class B bonds and shareholder equity. For Class A bonds to lose money, the portfolio that Astrea IV invests in must lose at least 64.4% of its value. So, it is quite safe, isn't it?



First of all, you need to recognise that Astrea IV, the company that you are investing into by buying the retail bond, is essentially a fund of funds. Although its LTV is capped at 50%, this is only at the Astrea IV level. The funds that Astrea IV invests into could have their own borrowings and these are not counted in the 50% LTV cap. After accounting for these borrowings at the lower levels (i.e. look-through basis), the leverage could be much higher. As a hypothetical example, Company A could have shareholder equity of $50M and bonds of $50M. Using this $100M, Company A invests into Company B. Company B borrows another $100M. Company B invests the $200M into a property. How much of the investment in the property is funded by equity and borrowings? The answer is $50M in equity and $150M in borrowings. Thus, even though the LTV at Company A's level is only 50%, on a look-through basis, the LTV is 75%! Does LTV on a look-through basis matter? For Company A's equity to be wiped out completely and its bonds to start losing money, the property's value only need to fall by 25% ($50M equity out of $200M asset value). So, LTV on a look-through basis does matter!



Secondly, most of the money are invested in buyout funds. Buyouts are usually highly leveraged operations. In the process of buying out companies, they take on large debts and usually pay a premium to acquire a 100% stake in the companies. After successfully acquiring the companies (which are usually cashflow-rich companies), they extract most of the cash from the companies to pay down their own debts. They also streamline the operations of the companies and load them with debts, such that the companies become more conscious about cutting costs and direct most of their cashflows to paring down the debts loaded onto them. Thus, the high returns of buyout funds are partly due to making the companies more efficient and partly due to the leverage employed. As an example, when 3G Capital teamed up with Berkshire Hathaway to buy Heinz for USD23.3B in 2013, they only forked out USD4.4B in capital each. The remaining was borrowed. (Note: Berkshire Hathaway also bought USD8B of preferred stocks paying 9% interest. I will leave it to readers to decide whether to classify this USD8B as equity or debt.)



Thus, in conclusion, Astrea IV is essentially a fund of leveraged buyout funds. I will not be investing in these bonds, even if its 4.35% coupon looks attractive.





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Understanding the Safeguards of Astrea IV 4.35% Bonds
- Original Post from (The) Boring Investor

Astrea IV 4.35% bonds are unusual retail bonds as they are backed by Private Equity (PE). There are 5 safeguards put in place by the issuer to ensure that cashflows from PE investments are adequate to meet the obligations of the bond. These are:



  • Reserves Accounts

  • Sponsor Sharing

  • Maximum Loan-to-Value (LTV) Ratio

  • Liquidity Facilities

  • Capital Call Facilities



To understand why these safeguards are important and necessary, let us consider a hypothetical scenario in which I wish to issue Boring Investor bonds to retail investors to raise capital to invest in public equities listed on the SGX. Cashflows for the bonds would come from sale of equity investments and dividends from investee companies.



Generally, the Straits Times Index (STI) generates annualised returns of 7% in capital appreciation and 3% in dividends on average. To entice investors to my Boring Investor bonds, I would probably have to pay interest rate of 5% on the bonds. The first question that comes to mind is how do I ensure that I could meet the 5% interest obligations on the Boring Investor bonds on a sustainable basis when I could only receive 3% dividends from the equity investments? There are several things I can do, as described below.



Maximum Loan-to-Value (LTV) Ratio



Supposed I intend to invest $1M in the SGX equities. At a dividend rate of 3%, the maximum dividends I could get from the equities annually is only $30K. Based on the bond interest rate of 5%, the maximum amount of Boring Investor bonds I could issue is $30K / 5%, or $600K. The maximum Loan-to-Value (LTV) ratio that can be supported by dividends on a sustainable basis is only 60%. Thus, by setting a maximum cap on the LTV ratio, I can better ensure that bond holders are paid on time.



Liquidity Facilities



There will be times when the economy is not doing well and the investee companies have to cut dividends. When this happens, I might not get sufficient dividends from the equity investments to pay interest to bond holders. I will need to borrow money temporarily from the banks to pay the bond interest.



Capital Call Facilities



There will also be times when some companies need to issue rights issues to raise money. Given that most the funds raised from the Boring Investor bonds have been invested in the SGX equities, I might not have sufficient funds to subscribe to the rights issues and buy additional shares in the companies at a bargain. To guard against this, I can set up a credit line with the banks to temporarily borrow money to subscribe to the rights issues.



Reserves Accounts



Given the unpredictable nature of the cashflows from dividends and sale of equity investments, it is prudent to set up a sinking fund to save some excess cashflows after paying the bond interest and other necessary expenses. The amount to be set aside for the sinking fund each year is a pre-determined amount, but it is only set aside if excess cashflows are available. The sinking fund will be topped up until there are sufficient funds to redeem the Boring Investor bonds in full. This would increase the likelihood that the bonds could be redeemed in full when they mature.



Sponsor Sharing



Generally, after meeting all the obligations mentioned above, any remaining cashflows would belong to the sponsor shareholder. However, as an additional gesture of goodwill, I can share the remaining cashflows 50:50 with bond holders if certain performance threshold is met by a certain date. The cashflows shared with bond holders would be used to top up the sinking fund mentioned above, if it is not full yet.



Conclusion



As you can see above, cashflows from equity investments (more so for PE investments and PE funds) are unpredictable, irregular and discretionary whereas interest and principal repayment obligations of bonds are fixed and mandatory. There is a need for some of the above-mentioned safeguards (known as credit enhancements) to ensure that bond obligations can be met when they fall due. If there were no credit enhancements, and the fixed and mandatory bond obligations were solely funded by the irregular and discretionary cashflows from equity investments, defaults on the bonds would likely happen at some point in time.



Thus, the Astrea IV 4.35% bonds are safe mainly because of the safeguards put in place. It is not a bond, but a structured bond. The credit ratings for Astrea IV 4.35% bonds are expected to be "A(sf)", with "sf" denoting structured finance. To avoid confusion with traditional bonds, it is best to refer to the Astrea IV 4.35% bonds as structured bonds, just like we differentiate structured deposits from fixed deposits.



Did I invest in Astrea IV 4.35% bonds? No, I did not. I prefer to invest in traditional bonds in which the underlying cashflows are sufficient to meet the bond obligations without any credit enhancements.





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Possibly The Worst Time to Invest – 4 Years On
- Original Post from (The) Boring Investor

This once-a-year post probably sounds like a broken record, but 4 years after I thought it was a bad time to invest (due to record high Dow Jones Industrial Average and record low interest rates then), the DJIA has not crashed yet, despite a series of corrections along the way, with the most recent one in Feb. I have 2 passive portfolios invested in index funds and adopting the portfolio rebalancing strategy. The plain vanilla portfolio has 70% in global equities and 30% in global bonds since Dec 2013, while the spicy portfolio has 70% in US equities and 30% in Asian bonds progressively built up over 2015.



To-date, the plain vanilla portfolio is up by 31.4% while the spicy portfolio is up by 24.2% since they were started approximately 4.5 years and 2.5 years ago. Needlessly to say, had I worried about the high stock prices and low interest rates back then and not started the 2 portfolios, I would not be sitting on such paper gains.



I am tempted to allocate more money from my active investments to the 2 passive portfolios, considering that all it takes is to monitor occasionally whether the relative allocation between the equities and bonds has moved significantly away from the initial allocation of 70% stocks and 30% bonds and rebalance them when it happens. In contrast, active investment requires a lot of hard work. I need to read the financial statements and annual reports, attend Annual General Meetings, understand pricing strategy and competitors' activities, etc. to understand how well the business is doing. Just take a look at M1, a stock that I blogged about recently. I spent no less than 6 posts (and another 3 posts on its competitors) to describe the various aspects of M1. Even then, there are probably still a lot of areas about M1 that I do not understand. Furthermore, the size of my M1 position is only 1/3 that of the 2 passive portfolios!



So, would I be worried if I were to invest more into the 2 passive portfolios and the crash finally happens? Obviously, I would be quite upset if it were to happen, but I would attribute it more to bad timing. One way to mitigate this risk is to spread out the investment, similar to what I did when I initiated the spicy portfolio. The plain vanilla portfolio was a lump-sum investment in Dec 2013, but the spicy portfolio was built up over 12 months in 2015. Furthermore, the rebalancing strategy will ensure that if stocks were to crash significantly, the bonds would be sold to buy more of the now cheaper stocks. There is inherent defence mechanism in the portfolio rebalancing strategy.



This time next year, I am not sure if I will be happy or upset over my 2 passive portfolios (which depends on whether the crash happens or not), but likely, it will be business as usual.





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