Introduction

The offer by Laparkan to distribute 480 bond units of five million Guyana Dollars each (total $2.4 billion) is a welcome addition to the dearth of securities available in Guyana for investments. If the issue is successful and the bond is fully subscribed this will give the development of the Capital Market in Guyana a much-needed boost.

Although the issue is a private placement, and as such will only be sold to fewer than 50 subscribers, this analysis has been undertaken in the hope that in future more companies would adopt the corpo rate bond route. If companies choose to make a public offer or tender, an understanding of the analysis provided here would enable potential investors to appreciate the important factors and considerations when investing in corporate bonds.

The Bond has been offered by way of a Memorandum. It is not stated in the Memorandum whether the distribution falls under Section 67 (2) or (3) of the Securities Industry Act 1998 ("the Act"). These sections grant exemption from Sections 61, 62 and 63 of the Act, which require that a prospectus accompany a distribution. Section 61 states that "Subject to Section 62, no person shall distribute a security unless a prospectus or a block distribution circular has been filed with and a receipt therefor has been issued by the Council." In the case of Section 67 (2) the exemption applies (subject to certain conditions) if the distribution is made to not more than fifty purchasers, each of whom is a sophisticated purchaser. Section 67 (3) applies to a limited offering, which is an offer made within such time as may be prescribed by the Council, to not more than fifty purchasers of the securities distributed (again subject to certain conditions).

If a distribution is not exempt from the requirement to issue a prospectus then this brings into play Section 64 (1) of the Act and the Securities Industry (Prospectus) Regulations 2002, which set out the information required in the prospectus. In this analysis it is assumed that this distribution is exempt from the prospectus requirements and as such we analyse the information provided in the Memorandum only to the extent that is needed to evaluate the issue. In any case, the Memorandum states it was lodged with the Guyana Securities Council and a receipt issued on January 29, 2004.

Returns on investment

Assuming that the company does not default, the bondholder will receive income (interest) and the repayment of the capital invested. In this case, the income is a net rate of interest of 8% per annum, payable half yearly and the capital is repaid in three instalments: 10% at the end of year five, 15% at the end of year six and the remaining 75% at the end of year seven.

The company also has the option to call the bond that is, to repay some or all of the remaining capital early (in amounts of $1million or multiples thereof) on any interest date by giving 180 days' notice.

The interest rate is also subject to a 1% increase or "step up" from the beginning of year 5 should the annual yield from the Government of Guyana Treasury Bill ("T-Bill") for the year preceding exceed 8%.

If the company does not call the bond, the repayment schedule (capital and interest combined) on one unit of the bond will be as follows (assuming a registration date of March 12, 2003):

Repayment Schedule after tax

How does this compare with other investments?

This looks like an attractive return - pay $5 million and in return receive between $7.7 million and $7.8 million. However, as with any potential investment, it must be viewed in light of the alternatives. The natural candidate would be the return on Government debt of an equivalent duration. Given that the longest term debt regularly auctioned by the Bank of Guyana is the one year T-Bill, this makes comparison with the returns on this instrument somewhat misleading, as the repayments on the bond are locked in (subject to the step up if the T-Bill rates exceed 8% immediately prior to year 5 and the option by the Company to call the bond). But the returns on an investment in T-Bills are unknown as the reinvestment rates are subject to uncertainty. In fact T-Bills interest rates have fallen dramatically over the last two years and are likely to remain low as long as excess liquidity remains in the banking sector and inflation remains benign.

Given this cautionary overture we can proceed to compare the current return on the one-year T-bill with that of the bond.

Tax

Returns on the bond are paid net. Whatever the tax status of the purchasers, they will receive 8% after tax. This means that the effective gross rates of return depends on the tax applicable to the purchaser as follows:

1) Where 20% withholding tax is applicable the gross interest rate is 10%

2) Where corporation tax/income tax of 45% is applicable the gross interest rate is 14.55%. (Commissioner General of the Guyana Revenue Authority, Kurchit Sattaur says Laparkan will not be able to pay a net rate of interest to commercial banks which may subscribe to the bond issue because corporation taxes are not deducted at source like withholding taxes.)

3) Where there are no applicable taxes the gross interest rate is 8%

The notice of the most recent one-year T-Bill auction at the time of writing (B219) states that the annualised yield on the previous issue was 4.243%. This is subject to withholding tax at 20% so the net yield of holding the one-year T-Bill at this rate would be 3.394%

When analysing returns on bond issues it is important to compare like with like. The yield on the bond is not 8% as this rate does not allow for the fact that the payments are made half-yearly rather than annually and would add up to more than eight per cent.

The redemption yield gives a more accurate statement on the rate of return and equates the present value of the repayments with the consideration paid. The gross redemption yield is before tax while the net redemption yield allows for the tax position of a particular investor. The redemption yield can be used to make direct comparison between different bonds.

The following table shows the gross redemption yields (GRY) with the spread that is the excess return over the gross T-Bill rates respectively if the bonds are not called in early:

The spread over the T-Bill is not shown if a step up in interest occurs, because this entails the T-Bill rate to be 8% by year 5, invalidating any comparison with the current rate.

The net redemption yield is 8.16% if the interest does not step up, the spread over the net T-bill rate of 3.394% is 4.61%, which would be a very large pick up in yield if the comparison was being made with a government bond of the same duration. By comparison gross credit spreads on high quality corporate bonds in developed markets average between 0.5%-2%. The net redemption yield if the interest does step up would be 8.581%

One other important comparison to make is with inflation. Investors often require a real return. That is, the return on their investments must at least outpace inflation. The latest year-on-year rate published shows inflation at 5%. If inflation remains about this rate then the bond would yield a net real return of around 3%, which looks very good on paper. However, it only takes inflation to rise one or two percentage points over the life of the bond to erode the returns in real terms. A return to the double digit inflation which Guyana saw in the past early in the life of this bond would see the real returns on this investment wiped out, which illustrates one of the risks of holding fixed interest securities such as this bond.

Of course the big difference between government debt and a company is that the Government is extremely unlikely to default on its domestic debt. The ability of a company to repay depends on it continuing to make profits and generating cash flow.

The value to the Company of the option to call the bond

Whether or not the bond would be called in future depends crucially on whether the company could refinance its debt at a cheaper rate in the future. Assuming there is a recall, then this largely means that the Company could borrow on cheaper terms than the 8% net cost they would pay on this bond. Three likely scenarios that could cause the company to refinance are as follows:

1. The general level of interest rates falls.

2. The credit spread required by the market on Laparkan's debt reduces.

3. One or more investors in the cheaper tax brackets come forward.

Of these, the first perhaps bears the greatest risk for potential investors since they feel they are locked into an 8% net return but would end up with their capital returned and having to find outlets to reinvest same in a climate of even lower interest rates than currently available. The extent to which the second point poses a risk depends on the availability of alternative investments at the time the bond is called. Given the lack of a secondary market for debt in Guyana, and the infrequent tapping of the primary market, it seems quite likely that the only available investment will be whatever the Company issues at that time, which is almost certain to be at a lower rate otherwise the company would not bother with refinancing!

One approach to valuing an option of this type is to model the T-Bill rate, for example, with the Hull and White model for short-term interest rates, though such a valuation is beyond the scope of this article. Note the value of the option is to the Company, so this reduces the value of the investment to the purchaser.

Financial statements

The financial statements are critical in understanding the impact the debt will have on the financial position of Laparkan Holdings Limited (LHL) - the Group). LHL acquired 100% of Laparkan Investments Ltd (LPKI), the international operations, in January 2003. Although the forecast statements for 31 January 2004 have been consolidated for the Guyanese operations in the Memorandum, unfortunately the financial results for LPKI have not been included in the consolidated statements and the results provided for LPKI are only summary statements. The Memorandum does say that the financial statements to 31 January 2003 are available for inspection at the Head Office, and any potential purchaser of the Bonds would be wise to review the full statements so that the following analysis can be carried out with complete information.

Since complete information has not been provided in the Memorandum, the profit before interest and tax figures for LPKI used in this analysis have been estimated by assuming no tax (which may apply if LPKI is an Exempt Guernsey company), and interest on the average loan balance of LPKI equal the rate of interest paid on the average debt of the local operations (including that due in less than one year and the bank overdraft).

Including the 31 January 2004 forecast figures, the memorandum also contains projections from 2005 to 2011 (the lifetime of the bond). The auditor's statement only appears to cover the 31 January 2004 forecast for the Guyana operations, since it refers specifically to forecast "as set out on pages 31 and 32". If this is the case, then there does not seem to be any independent statement in the Memorandum as to the applicability of the projections or the 31 January 2004 forecast for LPKI.

The Memorandum states the 2005 to 2011 projections "...have not been fully consolidated in accordance with standard practice." This is also unfortunate. To be able to assess the impact of the bond, the entire finances of the Group need to be analysed. Nevertheless the following analysis has been carried out assuming that the projections are based on fully consolidated figures.

The 1999-2004 figures for the Group in this analysis have been arrived at by totalling the 31 January 1999-2003 figures as well as the 31 January 2004 forecast provided for the Guyana operations and LPKI, plus the estimated LPKI interest expense:

G$ millions

1999

2000

2001

2002

2003

2004 (1)

2005 (2)

Turnover

4,641

4,803

5,646

6,014

7,236

8,416

11,315

Net Profit for Year

104

122

21

122

92

40

135

Interest

74

91

76

68

82

143

382

Tax less adj to reserves

36

37

39

39

46

31

92

Minority Interest

7

6

7

3

0

7

21

LPKI Interest Estimate

14

19

23

19

26

Estimated Profit Before Income and Taxation

270

162

255

239

247

630

(1) From 31 January 2004 Forecast (2) Direct from projections from Memorandum

Capital Cover (security)

The security on the bond is provided by way of Debenture on the fixed and floating assets of companies in the Group. Full details are set out in the Trust Deed which "...sets out in detail the rights and obligations of Trustees in respect of the charges on the property securing payment of Principal and Interest due on the Bonds and sets out the restrictions and obligations of LHL and the other Secured Companies providing the charges".

A fixed charge means specific assets have been identified as security and they cannot be sold, transferred or otherwise disposed of other than to meet the obligations to the bondholders. A floating charge means that specific assets are not identified as security though in the event of default the charge will usually crystallise prohibiting the disposal of the assets which are not security for a fixed charge except to meet the creditors. This permits the Company to make best use of its assets covered by a floating charge in the running of the business while providing reassurance to the bondholders that in the event of default the interests of the bondholders will be looked after.

This bond provides a first charge on the assets of William Fogarty Ltd, Laparkan Trading (Guyana) Company Ltd, Jim Bacchus Travel Service Ltd, Laparkan Financial Services Ltd, and Laparkan Airways Guyana Ltd and a second charge on the assets of LHL. This means that after the first Debenture on the assets of LHL has been repaid, the bondholders would be the next creditors standing in line. In this analysis it is assumed that the "Loan from major shareholder" is the first Debenture on the assets of LHL.

Although the Memorandum states that the trust deed sets out the obligations and restrictions on the Secured Companies during the existence of the security it does not elaborate on what these are. A potential investor may wish to examine the Trust Deed to find out whether there is any restriction on the Company issuing any more debt. Even the issue of further lower ranking debt might adversely impact the ability of the Company to repay its current obligations and the issue of higher-ranking debt would dilute the security currently provided to the bondholders.

A good measure of the security of a particular tranche of long term debt is to study how many times the assets of the Company cover that debt and all equal and prior ranking debt or the inverse, what proportion of the assets would be needed to repay a particular tranche. These measures are the capital cover (also called asset cover) and asset priority percentages respectively. In these measures assets are defined as total assets less current liabilities and exclude the minority interest.

Typically, the analysis is done based on the latest balance sheet date, assuming the issue is fully subscribed and the proceeds raised by the issue are added to the asset figure. Also shown here are the figures using the 2005 projections.

Using 2004 (assets G$6,067M *)

Using 2005 (assets G$7,191M)

Amount (G$M)

Capital Cover

Asset Priority Percentages

Amount

(G$M)

Capital Cover

Asset Priority Percentages

Loan from Major S'holder

976

6.22x

0.0% to 16.1%

1,005

7.16x

0.0% to 14.0%

Bond Issue

2,400

1.80x

16.1% to 55.6%

2,400

2.11x

14.0% to 47.4%

Other Long Term Borrowings

1,310

1.29x

55.6% to 77.2%

976

1.64x

47.4% to 60.9%

* After adding G$2,400M

Such a look at the security of the debt, broken down by the pecking order, suggests that even if fully subscribed, there will be plenty of assets as security to cover the bond issue. Even the lower ranking debt remains reasonably well covered. The 2004 analysis ignores the fact that some of the capital raised from the bond will be used to repay this debt. The 2005 projections show lower long-term borrowings such as those falling due after one year so it seems reasonable to assume that the company took account of it.

Income Cover

The income cover assesses how many times income before profit and taxation covers the interest repayments on each prior and equal ranking tranche of debt. Although in the short-term a company can finance debt payments if it is not making profits, in the long-run if it is not generating a return then it will find it increasingly difficult to generate the cash flow needed to make repayments.

Again the analysis is shown assuming the debt had been raised in 2004 and also based on the 2005 projections. Note the 2004 profit before tax estimate may be understated if the interest estimate for LPKI is too low or there was in fact tax paid.

These analyses are necessarily broad brush in that they are based on the interest payments from the forecast statements for the Guyanese operations for 2004 and assume that the average rate of interest from these statements (including debt shorter than one year and any overdraft) is payable on the loan from the major shareholder. The interest on other borrowings has then been found by subtraction. Ideally, the exact amount of interest payable should be determined for each tranche separately, by examining the specific terms of each tranche of debt.

Income cover represents how much profit before taxation covers the debt repayments of all equal and priority debt and income priority percentages reflect how much of the income goes to servicing each tranche of debt. The upper range of the income priority percentage of the lowest ranking long-term debt is also known as the income gearing.

The interest on the bond payable reflects the average gross rate payable, and as in the Memorandum is assumed to be 12.5%

Using 2004 (PBIT G$247M *)

Using 2005 (PBIT G$630M)

Estimated Interest Cost G$M

Income Cover

Income Priority Percentages

Estimated Interest Cost G$M

Income Cover

Income Priority Percentages

Loan from Major S'holder

60

4.12x

0.0% to 24.2%

60

10.52x

0.0% to 9.5%

Bond Issue

300

0.69x

24.2% to 145.7%

300

1.75x

9.5% to 57.1%

Other Borrowings

109

0.53x

145.7% to 189.8%

22

1.65x

57.1% to 60.6%

* Estimated - see table above for derivation

Note that the other borrowings are much more important in the analysis of income cover because a failure to repay interest to even a lower ranked creditor could trigger a liquidation of the Company and hence the repayment of all prior ranking debt as well.

This issue highlights a potential cause for concern: based on the figures above current revenue would not be sufficient to meet the projected interest costs of this issue (this is signified by an income cover of less than 1 or equivalently an income priority percentage greater than 100%). Income must be generated from the capital raised in order to support it. However, half of the capital being raised is used to re-finance existing debt so it will not be used to generate income before interest and tax (though it will dramatically reduce the cost of servicing the other borrowings as the 2005 projections show).

The 2005 projections show a much healthier picture, with income cover close to two times on the bond, which would usually be considered the bare minimum for a company with stable profits such as a retailer. An investor may demand a higher income cover before investing in a bond from a company with a more volatile income stream.

Since it seems the ability of the Company to generate the income needed to cover the interest on this bond depends on it increasing profit before tax, an analysis of the projections is necessary.

The 2005 - 2011 projections

Unfortunately, it is at this stage that only having Turnover and Net Profit/(Loss) for LPKI in the Memorandum really hampers the analysis. Although an estimate of profit before tax has been used for calculating the income cover above, using the same assumptions in this analysis to generate profit before tax would inevitably lead to the same conclusion.

The trend in gross profit and return on capital employed would allow an assessment of the reasonableness of the projections; however both of these ratios require profit before tax to calculate them. The only figures for which trends can be readily analysed without making assumptions are turnover and net profit.

Turnover looks set to increase by 16% from G$7,236M in 2003 to G$8,416M in 2004, the projections show an increase by 35% to G$11,315M in 2005. Net profit shows a downwards pattern from 2003 to 2004, falling 56.5% from G$92M in 2003 to G$40M in 2004 (though this may well be due to rising interest costs which would be stripped out of an analysis of profit before tax). The projections show net profit up from G$40M in 2004 to G$135M in 2005, some 238%. Again this figure is likely to be distorted by the impact of refinancing rather than a huge increase in fundamental profitability.

Of course anyone sent the Memorandum would be entitled to view the full financial statements for the LPKI and would thus be able to make an informed analysis of the projections.

The $5,000,000 question

Whether this bond is suitable to a particular investor will depend largely on whether they consider the attractive rate of interest on offer sufficiently compensates them for the potential risks that the Company defaults on the interest or capital, inflation erodes its value or the capital is repaid early at a time when only lower returns are available. Although the capital cover suggests that even in the event of default on interest there are sufficient assets to repay the bondholders, these ratios are based on the values of the assets shown in the accounts assuming the company remains a going concern and may not represent realisable values. More significantly, the income cover calculation above suggests that in order to provide adequate cover of the projected interest the profit before tax of the Group must increase substantially over the figures shown for the Guyanese operations in the 31 January 2004 forecast and the LPKI estimates. In the event of a default on interest, even if the bondholders eventually get their capital back there may be a substantial opportunity cost in terms of lost interest while the assets are liquidated and the bondholders repaid.

Patrick van Beek is an Actuary by profession. He is acting Chief Executive Officer of the stock exchange and also a member of the board. Mr. van Beek was involved in the financial sector since 1994, first as an actuarial student for Generali Worldwide (a subsidiary of the Italian Insurer Assicurazioni Generali Spa) where he worked in close collaboration with the investment management committee selecting suitable corporate bonds to match the annuity portfolio. He has since worked for the insurance division of the Actuarial consultancy Bacon & Woodrow (which merged with Deloitte & Touche to become B&W Deloitte) and also worked on a contract basis calculating compensation for individuals who were miss-sold personal pensions.

Mr. van Beek moved to Guyana to set up his Actuarial practice, Caribbean Actuarial & Financial Services. Subsequently he was contracted by Adam Smith Institute (who provided much of the technical support for the Capital Markets project in Guyana) to set up the operational aspects of GASCI, including registering GASCI with the Guyana Securities Council and