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UACN BOND: A LOSER LOOK


By: Uche Ndimele
Published Augus 27th, 2010
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According to the daily independent newspaper of August 24th 2010, “management of UACN Property Development Company has said that its N15 billion bond issue was oversubscribed by 100 per cent. According to the same paper “The coupon on the bond will be paid semi-annually in arrears, while the principal will be repaid in six equal semi-annual installments commencing on February 17, 2013”.  With that bond issue, UACN has a whole lot of firsts. It is the first and only listed real estate Company in Nigeria, “it is the largest corporate bond issue in the history of the Nigerian capital markets and the first bond issue to get a credit enhancement” and it is “the first non-bank corporate bond in recent times” and it is the first company to issue a serial bond in Nigeria. Succinctly put, Serial bonds are the bonds which though are issued together get matured on different dates unlike term bonds which have a single maturity date. From this definition one can see that UACN effectively issued 6 distinct bonds of N2.5 billion each with different maturities. As follows:

Bond Amount Coupon Maturity Date
1 N2.5b 10% 2/17/2013
2 N2.5b 10% 8/17/2013
3 N2.5b 10% 2/17/2014
4 N2.5b 10% 8/17/2014
5 N2.5b 10% 2/17/2015
8 N2.5b 10% 8/17/2015

I must applaud the management of UACN for using this type of financing arrangement because, in all intents and purposes, serial bonds are most suitable for projects with regular level debt payments like residential developments. Unlike a term or flat bond, which may require the issuer to set up a sinking fund, (not sure if Nigerian Regulators require this), serial bond has the advantage to the issuer of smoothening their cash flow because it is known when and how much will be repaid at every maturity period. The issuer also has the advantage that the interest burden gets less as the installment principal repayments are made. Unfortunately, serial bonds do not offer the flexibility that a callable bond offers. With a callable bond, the issuer decides whether to call or not and when to call. The callability or otherwise of a callable bond depends, however, on  movements in interest rate such that if interest rate increases, the issuer ends up better off not calling the bond. With that flexibility, one begins to wonder why UACN decided to issue a serial bond and not callable bond. May be their financial  crystal ball gazer or futurist, called analysts in finance parlance, told them that interest rate in Nigeria is bound to increase within the next 5 years so much such that there would be no need to call the bond. This could be a reasonable assumption in the light of the rumor or fact that Nigerians low yield is driving capital to Ghana (see the article entitled “Nigeria’s low yields boost trading in Ghana’s securities”- BusinessDay, July 9th 2010). Again, the management might have thought that a callable bond, as an option embedded instrument might not be priced as high as a serial bond because of the call option the issuer has. I am sure that a lot of thought must have gone into the process before the financial decision to go for a serial bond. But what do the investors think? By virtue of the fact that the issue was over subscribed by 100%, one can deduce that the investors think it is a good deal or could the over subscription is due to the Nigerian market being awash with so much liquidity and are therefore looking for investment outlets?. Your guess is as good as mine.

Valuation

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For the bond to have been issued at par, it implies that the coupon is equal to the yield to maturity (YTM), because the bond price yield relationship posits that when the coupon rate on a bond is the same as the current yield as well as the yield to maturity, it should sell at par while a bond whose yield to maturity exceeds the current yield which in turn exceeds the coupon rate should sell at discount. In the same vein, a bond with a coupon rate that is greater than current yield and in turn greater than the yield to maturity should sell at a premium. One can validate the par value at issue by calculating the yield to maturity of the bond. Being a serial bond, the easiest way to do this is to consider the principal repayments as payments rather than maturities. By so doing the YTM can be calculated as the internal rate of return, IRR. Using the cash flow below ( for brevity, I omitted the zeros that represent billions and worked with millions), it can be verified that the semi annual IRR is 5% which translates to an annual IRR or YTM of 10%, this is the same as the coupon rate, hence the validation that it was properly priced at par.

Risk Analysis

Investors who bought this bond may be interested in knowing what type of risk this transaction exposes them to. Bond transactions expose investors to default risk, which is the risk that UACN will be unable to meet its obligations with respect to interest and principal payments as at when due. Given the track history and the performance of the company over time and the nature of the project for which the bond was issued, it is expected that the probability of default is very low. Furthermore, the credit enhancement that the bond has, reduces credit/default risk of a debt

One worrisome thing though, is that half of the proceeds from the bond issue will be used to service other bank loans. According to the Daily Independent, “The Managing Director of UPDC, Mr. Hakeem Ogunniran, said half of the proceeds from the bond would be used to finance outstanding short-term bank facilities and the rest to fund the development of various estates, residential and commercial, which the company is currently executing all over the country”.  This decision will be a good one, if the interest rate on the bank loan is more than the coupon rate on this bond, otherwise, the rationality of such decision will be called to question.

Another risk that investors may run into is downgrade risk; this is the risk that the rating agencies will downgrade the bond from its current rating to a lower rating. The implication of this is that the price of the bond will decrease and as such current holders may not realize a good profit if they decide to sell. Again, with the current financial condition of UACN, downgrade risk may not be a thing to worry about within the term to maturity of the bond.  There are a whole lot of other risks that a bond holder is exposed to, like political/regulatory risk which may be a risk to be worried about given the current events in the Nigerian financial system and political environment.

Another risk that may be of concern is purchasing power risk, which is the risk that the cash flow from the bond will be worth what  it was when the investment was made in, real terms. With the current rate of inflation for Nigeria, at 11.5, according to the CIA World Factbook, the real rate of this bond is 9%, if the rate of inflation increases between now and 2015, the real rate will decrease and bond holders will experience purchasing power risk.

One major risk that a holder of this bond should really worry about is reinvestment risk. Reinvestment risk is the risk that the proceeds from this bond will be reinvested at a lower interest rate. This risk will be more felt from 2013 when the installment maturity starts. This however, will depend on the market rate then but from the look of things, it appears that interest rate is already low in Nigeria so, the likelihood that it will go lower is relatively remote.

Another major risk an investor should worry about is interest rate risk. This is the risk that the price of the bond will fall as interest rate rises. This is taken from the inverse relationship between interest rate/yield and bond price. As noted above, interest rate is more likely to rise in the future and the more that happens, the more apparent the interest risk on this bond.

Measuring interest rate risk

A measure of interest rate is duration. Duration is a measure of a bond’s sensitivity to movements in interest rate. From my quick and dirty calculation, the duration of the UACN serial bond is 3.041, meaning that for a 100 basis point change in interest rate, the price of the bond will change by 3.04%. The implication of this is that if a bond holder holds one million naira worth of this bond, and market interest rate increases from 10% to 11%, the bond will be worth nine hundred and sixty nine thousand, six hundred naira and if interest goes from 10% to 9%, the bond will be worth one million and thirty four thousand naira. The good thing about this bond is that because it is a serial bond, the installment maturity feature reduced the duration and its sensitivity to interest rate changes.

Conclusion

The UACN bond is a good investment with a coupon rate of 10% especially in a current situation where yield is so low in Nigeria. The risk as enumerated above is not unique to this bond, but to every bond though the effect and extent differs. It is expected that the current low yield in Nigeria will not go lower, if this correct; the investors may experience a price decrease in the bond as a result of rising market interest rate although this is not expected to be much considering the low duration of the bond.  From the above analysis, I can only say, aha! I now know why it was over subscribed.

About Me

I work as Assistant Vice President, Portfolio/Hedge Fund Accounting and Valuation Analysis for JP Morgan Fund Services in New York. I hold the Chartered Alternative Investment Analyst (CAIA) certificate and am also a professional Risk manager (PRM) having met the conditions required by the Professional Risk Managers International Association (PRIMIA).  I am a certified QuickBooks Pro Advisor and I have an MBA from the University of Phoenix, Arizona.

Uchey Ndimele, Bs (Econ) Ms (Econ) MBA (Acct), CAIA, PRM



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