by: Tam Ging Wien
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Just about the same time last year, Temasek owned Azalea Group issued what is believed to be the very first Private Equity (PE) Retail Bond backed by cash flows from a diversified portfolio of PE funds – known as Astrea IV. Astrea IV’s retail tranche offer was for $121mil Class A-1 bonds carrying an interest rate of 4.35%.
Just this week, Azalea Group announced the second issuance of Retail PE Bonds – known as Astrea V. This time, Azalea increased the tranche size by close to 50%, offering retail investors $180mil Class A-1 bonds carrying an interest rate of 3.85%.
In this article, we will be looking at the valuation of these bonds. We will only focus on the Class A-1 retail tranche available to retail investors, therefore through this article, where Astrea V is mentioned, we refer specifically to the Astrea V Class A-1 Retail PE Bonds.
We will only summarise the key basics that you need to know about these retail PE bonds, but we will not go into detailed as quite a number of our blogger friends have already covered it in detail. I highly recommend reading their articles for a deeper context of the Astrea PE Bonds:
Astrea V Class A-1 Retail PE Bonds:
Just for completeness, Private Equity or PE for short; are funds which invest in privately owned unlisted businesses and companies. They usually seek out high quality businesses with strong cash flow generating models and acquire them using borrowed funds. The they search for ways to increase their efficiency and increase their value – techniques include cost cutting and merging with other complimentary businesses to gain economies of scale with the aim of selling them at a higher price or listing them on an exchange via an IPO.
Azalea Group has published a few good videos which I recommend investors to watch to gain a better understanding of Astrea V:
Bonds are fixed income securities contract that represent a loan made by the bond investor to the bond issuer. In return, the issuer promises to pay the investor a fixed interest until the due date when the issuer is required to return the principal back to the investor.
In the case of Astrea V Class A-1 Retail PE Bonds, retail investors are making loans to Azalea Group to invest in private equity funds. In return, Azalea Group promises to pay investors 3.85% interest annually on their principal for the next 10-years. Upon maturity 10-years later, Azalea Group will return the principal back to the retail investors.
Investors should note that the Astrea V are callable in 2024 (5-years) which means that is Azelea Group is able to meet all payment obligations to the investors, they will redeem the bond early and return the principal to investors.
Upon issuance, bonds are set at “par value”, in the case of Astrea V this would be $1,000 each. Upon call or maturity, Azelea Group will return investors the part value of each bond they hold, i.e. $1,000.
As the Astrea V bonds are traded on the Singapore Exchange, their market prices may fluctuate from time to time which will affect its yield. At $1,000 par value and 3.85% interest rate, Azelea Group will pay investors $38.50 each year.
Let’s take a few hypothetical scenarios:
Regardless of the price in the market, Azelea Group will still pay bondholders $38.50 each year per bond. An investor that buys that bond at $900 will receive a yield of 4.28% for the remaining tenure.
Regardless of the price in the market, Azelea Group will still pay bondholders $38.50 each year per bond. An investor that buys that bond at $1,100 will receive a yield of 3.50% for the remaining tenure.
You will notice that in the 2 hypothetical scenarios above, when bond prices rise, their yields fall. On the other hand, when bond prices fall, their yields rise. The interest they pay are fixed, therefore bond yields are a result of market forces.
So, since an investor pays $1,000 for a bond, receives $38.50 for the next 5 years and gets his principal back, would that mean that the bond is worth $1,000 + $38.50 x 5 = $1,192.50? So, an investor holding this bond for 5 years would make a return of 19.25%? Naively yes, but it’s not that simple, it rarely is in investing!
The truth is, a dollar now is worth more than a dollar tomorrow! This is due to an effect called the time value of money. Over time, the purchasing power of the dollar diminishes due to the impact of inflation. Therefore, the buying power of $38.50 today is much more than $38.50 a year from now. Likewise, the buying power of the $1,000 bond is worth much more today that it would be 5 years from now.
Given an interest of 3.85% (i) per year paid once a year on the anniversary of a bond’s $1,000 present value (PV), one year from now the future value (FV) is $1,038.50. This can be represented by the mathematical formula:
In a more generalised form:
If we use some algebra magic, we could use the same formulate to calculate the present value of money that we will get in the future discounting it by the inflation rate!
Let’s use the above formula to try to calculate what is the real value of the $38.50 one year from now assuming the inflation rate is 2.00%:
Interestingly, the first-year interest payment is worth only $37.75 buying power in today’s terms. What about the second-year interest payment, what would its buying power be worth today assuming the inflation rate is 2.00%?
Notice how the longer we wait for our bond coupon payment, the less it is worth? $38.50 is worth $37.75 a year from now and even less at $37.00 two years from now!
Okay, now that that we have firmly grasped that the longer we wait for our interest payments, the less buying power its going to have. Exactly how much diminishing buying power we have depends on how high Singapore’s inflation rate is.
Source: Singapore Department of Statistics
Plotting the historical inflation rate and taking an average over the last 10 years, we estimate the inflation rate to be approximately 1.83%.
Armed with our formula and a good estimate of Singapore’s long-term inflation rate average, lets now put together into a diagram what we have learnt:
The diagram above shows that the present purchasing value of our future bond interest will be at the 1.83% inflation rate assuming the coupons are paid out once a year and the Astrea V bonds are called on the 5th year in 2024.
Adding up all these future bond interest will give us our total present value of $182.37.
Does that mean now that we have made a profit of 18.237% over 5 years?
Well, not really, because we had to actually had to spend $1,000 per bond to invest in it for 5 years, its actually stuck with Azelea and we wouldn’t be able to do anything with it until 5 years later! So, $1,000 today is worth much less 5 years from now! This is known as opportunity cost, it’s the cost that we pay to inflation by taking this investment opportunity over another. Let us estimate what $1,000 is worth 5 years from now:
Based on our estimates, $1,000 five years from now is only going to be worth $913.32 in today’s terms. Looking at it in a different way, not investing that $1,000 today will only result in its value diminishing by 8.67% over the next five years.
Therefore, investing $1,000 today would give us $913.32 + $182.37 = $1,095.69 five years from now. In other words, the real returns that we are getting from the Astrea V bonds is 9.57% over the next 5 years, or on average 1.914% per year.
Don’t get us wrong, we are not trying to say that the Astrea V bonds are yielding lower than what they claim. In fact, this thought process applies to all forms of income investments including dividend stocks, REITs and bonds.
The impact of time value of money, inflation and opportunity cost is real, and the key take away from this article isn’t really about Astrea V, but rather about the importance of investing. While investing that $1,000 in an Astrea V bond will yield you a 9.57% return, hiding that under a pillow will yield you a negative return of -8.67% over 5 years.
Yes, indeed all investments carry risk. Taking a risk at investing for a gain of 9.57% is far superior returns than not taking any risk as all and guarantee a loss of -8.67%.
Unless you have the investment knowledge, skills, experience and access to investment assets that could potentially exceed 9.57% returns in 5 years, why not take a small risk and consider the Astrea V bond?
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