Introduction
Traditionally, shipping companies have relied on bank debt to finance their operations and the acquisition of vessels. The recent credit crisis and the tightening of credit conditions, particularly in Europe, are now prompting them to seek other forms of funding. One such alternative source of finance that has become available to shipping companies in recent times has been the international debt capital markets. Indeed, there is evidence of an increasing number of bond issuances by shipping companies from the end of 2009 and through 2010 and 2011. Shipping companies have opted for a variety of bond instruments, depending on their needs and market conditions. These have ranged from relatively straight forward “plain vanilla” corporate bonds through to more complex instruments such as convertible bonds and structured bonds. One alternative capital markets instrument that is now also emerging is the Shari'ah- compliant bond, the Sukuk. This article will consider the advantages and disadvantages of these forms of financing in more detail.
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Corporate Bonds
The use of bonds by shipping companies to raise finance is certainly not a new development in the shipping industry. Historically bond issuance by shipping companies has been less frequent and bond issuances typically have involved relatively small tranches which have been used to supplement much larger bank debt facilities. However, the end of 2009 and the first half of 2010 saw a surge in larger bond issuances by shipping companies, including several repeat issuances. For example, Mitsui O.S.K. Lines (O.S.K.) issued several series of bonds between 2008 and 2011 (including two issuances in 2009 and one in 2011 of ¥20 billion each, and one in 2009 of ¥30 billion) and has established a Medium Term Note programme listed in London.
Because of the fact that capital markets gives issuers access to a wider and more diverse pool of international investors, shipping companies would have the ability to raise finance at rates that could potentially be cheaper than those offered to them in traditional lending. And even if bond market interest rates prove to be higher than typical commercial bank lending rates, because of market volatility for instance, corporate bonds carry the additional advantage of being issued with longer tenors than bank loans, which can be advantageous to companies with long-term capital expenditure needs. In addition, the package of covenants (financial and otherwise) which a shipping company may need to cede to investors in a capital markets deal is typically lighter than that which would be imposed on it on in the context of bank lending.
Corporate bonds are the simpler form of debt capital markets instrument. A shipping company can either issue the bond directly (i.e. the shipping company itself is the issuer of the bonds), or use an offshore structure whereby the bonds are issued by a special purpose vehicle (SPV) established in an offshore financial centre, with the shipping company (as ultimate obligor) guaranteeing the performance of the SPV's payment obligations to the investors. The offshore structure can offer tax advantages (in relation to withholding tax liabilities) and make the internal corporate as well as regulatory approval process in respect of the issuance of the bonds less cumbersome for the company. In addition, "plain vanilla" bonds do not require the shipping company to encumber any of its assets as investors will in most cases not require security, which gives this form of funding an advantage over more traditional forms of funding (such as secured bank lending).
What shipping companies must bear in mind however in the context of any bond (and Sukuk) issuance, is that to the extent that the securities are offered to investors globally and/or are listed on a recognised stock exchange, the company will invariably need to produce an offering document which will contain extensive disclosure in relation to the company's business and financial condition, which offering document will be made available to investors and will likely need to be put in the public domain. The company will therefore be required to disclose publicly a whole raft of information which it would not otherwise disclose in a private deal, and would in addition be responsible for the content of the offering document, thus exposing itself to liability for any potentially material mis-statements or omissions. This is something that many shipping companies will not be accustomed to.
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Convertible Bonds
Another option open to shipping companies is to tap the convertible bond market. The increasing willingness of shipping companies to consider alternative forms of debt-raising structures has resulted in such companies issuing not only "plain vanilla" bonds but also more complex bonds, such as bonds which are convertible into equity at the option of the investor, the issuer, or mandatorily. The popularity of convertible bonds with investors depends on the state of the equity markets (either global and/or local), but recent times have seen small issuances of convertible bonds by shipping companies, such as the US$125 million convertible bonds issued by BLT Finance B.V. in 2007, convertible into ordinary shares of PT Berlian Laju Tanker Tbk, the US$110 million convertible bonds issued by Genco Shipping & Trading Limited in 2010 and the US$150 million convertible bonds issued by Hanjin Shipping Co., Ltd in 2011.
Convertible bonds are bonds that give the investor the right to convert the debt it holds (i.e. the principal amount it has advanced to the issuer) into, typically, newly issued shares of the issuer or of another company within the issuer's group. There are variations of the convertibility option, which, as mentioned, can be exercised at the option of the investor, or at the option of the issuer (where the issuer's shares are trading within or above a certain pre-agreed threshold) or can be mandatory (i.e. the bonds convert into shares mandatorily at maturity) or conversion can be dependent upon the occurrence of certain events, such as the company in question carrying out an initial public offering.
Convertible bonds can be an attractive financing option for shipping companies because offering investors an equity component would normally result in the convertible bonds bearing a lower coupon rate. It would also allow shipping companies to postpone an equity raising until a time where their share price is favourable enough for investors to want to opt into the equity. Convertible bonds can appeal to investors as well because they allow investors to hedge their investment risk, collect coupon during the life of the bonds and at the same time benefit from a potential capital appreciation if the underlying shares perform in the market.
On the other hand, the approval process can be more cumbersome for an issuer, because, depending on the structure used and the jurisdiction involved, the issuer may need to obtain, amongst other things, shareholder approval for the issuance of the bonds, shareholder approval for the issuance of the equity upon conversion (which may need to include a waiver of pre-emption rights) and approval from the securities regulator of the jurisdiction of its incorporation (for instance, in the United Arab Emirates, the securities regulator will need to approve the share capital increase necessary for the issue of new shares) and would need to make all necessary arrangements at the stock exchange where the new shares are to be listed.
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Covered Bonds and other structured bond financing solutions
Covered bonds
As reported recently by the Financial Times, January of 2012 was on track to be one of the busiest in more than a decade for global covered bond sales by banks.
Covered bonds (which may be either regulated or structured covered bonds) are popular with investors (and have become increasingly popular during the recent credit crisis) because of the fact that the securities are backed by a pool of assets, essentially a form of security, such as mortgages or other retail or commercial loans. Such assets are ring-fenced for investors even in bankruptcy of the issuer of the securities - in other words, if the issuer defaults, the investors would have recourse not only to the issuer-obligor, but would also have access to the underlying assets in priority to other creditors and would be able to liquidate such assets and apply the proceeds of sale towards repayment of the principal and interest due to them. Covered bonds can therefore benefit from a higher credit rating, which could potentially be higher than the issuer's own credit rating, and thus give the issuer access to a wider category of investors. For these reasons, covered bonds offer the issuer the ability to agree a coupon that would be more favourable (i.e. lower) compared to what it would need to pay investors on a "plain vanilla" unsecured deal. Recent examples of shipping financiers using this method of fund raising include HSH Nordbank's €500 million covered bond issuance in June 2010. Shipping loans could thus have a significant role to play in the development of the covered bond market in any event.
Shipping securitisations/off-balance sheet structured bonds
An alternative source of financing for both banks and shipping companies is the use of securitisation structures or off-balance sheet structured bonds.
Through these structures, banks with substantial shipping portfolios can refinance these assets by transferring the shipping loans (and relevant security) to an off-shore entity which in turn will fund its acquisition of the relevant portfolio through the issue of secured bonds. The banks continue to service the assets on behalf of the issuer of the bonds and as a result are able to maintain their relationships with their clients (within an agreed servicing framework).
Shipping companies can use these securitisation or off-balance sheet structured bonds to finance or refinance vessels or even securitise the cashflows generated by charter agreements. Title to the vessels is transferred to special purpose vehicles which will fund these acquisitions through the issue of secured bonds. Similarly to a shipping bank loan, the bonds are secured over the vessels, earnings accounts, insurance policies and (if any) charter agreements. Because of their off-balance sheet nature, the vessels and other assets granted as security are ring-fenced from the potential insolvency of the shipping company. Cashflows are structured in a tax efficient way and the relevant shipping company has access to any excess cash. Following the full redemption of the bonds, the full control of the vessels is transferred back to the shipping company.
These capital markets structures are extremely flexible as they can be adjusted to the needs of the relevant originating bank or shipping company and to the requirements or expectations of any class of investors which is being targeted. These bonds can be listed or privately placed, rated or not rated, issued as a single class or several classes of bonds. They can be structured (through a number of credit enhancement features) so that the rating or credit of the bonds exceeds that of the originating bank or shipping company, enabling (for example) a non-investment grade company to have access to investment grade funding.
In an environment where bank debt will become more and more expensive and difficult to obtain, structured bonds are a real funding alternative to senior secured bank debt for shipping companies.
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The Islamic finance alternative - Sukuk
A further bond financing alternative which seems likely to be explored further by more participants in the shipping industry is the issuance of Sukuk, the Shariah -compliant bond. The issuance of Sukuk by shipping companies to date remains relatively weak, and when they do occur, they are relatively small in size (for instance, Pacific Star's US$26 million Sukuk issued in 2005 to fund the acquisition of MT Venus Glory). This is despite the fact that shipping companies have traditionally used other forms of Shariah-compliant funding to finance their activities and expand their businesses. However, shipping companies looking to diversify their funding sources and which require long term financing, are starting to look at Sukuk as a potential method to raise capital.
Naturally, Sukuk involve more complex structures than conventional bonds. The certificates are based upon the use of underlying tangible assets, which are used to generate the cashflows required to service payments of profit to investors. The transaction will need to be structured in a way to ensure that it complies not only with the laws of the issuer's jurisdiction of incorporation and the law which the parties have chosen to govern the securities and related documentation, but also the relevant Shariah principles. Importantly, the issuer and financiers involved in the deal will need to scrutinise the tax laws in the jurisdiction in which the assets which are the subject of the Sukuk are located to ensure there will be no adverse tax consequences in respect of the use and/or transfer of such assets for the purposes of the deal (this is particularly the case in Ijara deals, as explained below).
Structures that could be used to support a Sukuk issuance by a shipping company are the Sukuk-al-Ijara structure, the Sukuk-al-Mudaraba structure and the Sukuk-al-Wakala structure (or a combination of the last two).
The Ijara structure, which is the structure which in most cases will be the most suitable for shipping companies, involves the sale of relevant real estate or non-real estate assets from the originator (the ultimate borrower - in our case, the shipping company) to a special purpose vehicle, and the lease of those assets back to the originator. The “rental” paid by the originator to the SPV is used to fund regular profit payments to investors. At maturity of the Sukuk, the originator undertakes to buy back the assets, thereby triggering the re-payment of principal. Shipping companies can use a vessel as the asset to back the Ijara, as the structure would permit the company to continue to benefit commercially from the use the vessel. In addition, although the vessel would be used to back the Sukuk, typically investors would not have access to the asset and would not be able to seize the asset and sell it into the open market in a default scenario. However, in order to achieve a transfer of assets in the Ijara scenario, the asset must be unencumbered and capable of transfer - this element might not always be possible for shipping companies which, as already mentioned, might have already granted security over their vessels in order to secure past debt financing.
As an alternative, shipping companies can use a Sukuk-al-Mudaraba or a Sukuk-al-Wakala structure (or a combination of the two). The Mudaraba is essentially a form of equity-based partnership arrangement whereby one partner (the SPV acting on behalf of the investors) provides capital (being the Sukuk proceeds) and the other (typically, the ultimate borrower) provides managerial skills. The Sukuk proceeds are invested in the Mudaraba enterprise in accordance with a pre-agreed investment plan - typically, this can be the business of the shipping company - with the purpose of generating profit on the principal amount. The Wakala on the other hand is a structure that is akin to an agency arrangement. A principal (the investors, acting through the SPV issuer of the Sukuk) appoints an agent (which, in certain circumstances, may be the ultimate borrower itself) to invest funds provided by the principal into a pool of investments or assets (which again can comprise assets of the borrower) and the agent lends its expertise and manages those investments for a particular duration in order to generate a pre-agreed return on the principal amount. One of the advantages associated with the Mudaraba and Wakala structures is that the parties will not need to identify at the outset a specific tangible asset for investment. The parties will however need to scrutinise the obligor’s business closely to ensure that it is such that can be utilised for the purposes of the investment plan and asset pool for which the proceeds of the Sukuk issuance will eventually be advanced.
Tapping the Islamic finance market would give shipping companies access to Islamic investors, an investor community which might have previously been unavailable to them. It would therefore enable issuers, at least in the current liquid Sukuk market, to obtain a more favourable pricing compared to conventional debt instruments (indeed, Sukuk are currently faring better in the secondary market compared to conventional bonds). It would equally give Islamic investors much needed diversity in terms of the industry origins of Sukuk issuers.
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Conclusion
The current trend of innovation in raising ship finance presents a significant opportunity for both shipping companies and financial institutions alike. It is anticipated that this trend will continue while bank lending remains in relatively short supply. Shipping companies which are assessing their future capital expenditure requirements could benefit from considering whether bond or Sukuk issuances might provide them with suitable financing alternatives. For shipping companies in good financial condition, the ability to raise debt financing without having to provide security will be an attractive option and one that many financial directors will want to consider. Indeed, it is anticipated that capital markets financing will become a permanent feature of shipping companies’ funding plans - and there is an argument that, in view of the current re-adjustment of global bank lending practices, it ought to be.
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