How Come There is No Market For Corporate Bonds In The Baltic States?

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Uppsala University

Department of Business Studies Master Thesis

2011-01-11

How Come There is No Market

for Corporate Bonds

in the Baltic States?

Authors:

Hampus Bengtsson Erik Kindblom Mikael Sahlberg

Supervisor:

Ulf E. Olsson

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Abstract

This thesis contributes to the understanding of why corporate bonds have not been commonly used as a funding source in the Baltic States. In the Baltics, bank loans are practically the only financial instrument used for companies in need of funding. This seems to be sub-optimal from a macroeconomic perspective, where empirical studies have shown that corporate bonds can mitigate the impact of an economic crisis. In order to accelerate the rebuilding of the economy, alternative markets outside bank loans would be preferable. The study is primarily based on a quantitative research but both quantitative and qualitative sources are used in a multiple method study.

The research concludes that there is a potential bond market in the Baltic States but there seem to be a lack of investors in the local Baltic markets. If companies due to this situation seek investors on the international market, more obstacles are in the way for these companies.

The most important aspect in explaining this dysfunctional bond market is the low interest rates of bank loans that are present in the Baltics. These have been low for a long time and the interest rates for bank loans were lower than those of bonds even back in 2004. Another aspect of explaining the problem has to do with the short sightedness of Baltic enterprises.

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Acknowledgements

We owe a debt of gratitude to many people for this work; people who have helped us understand the bond market and people who helped us with advice and encouragement. In particular, we would like to thank our supervisors Ulf E. Olsson, Uppsala University and Angelique Angervall, Swedbank. We would also like to send a special proof of gratitude to Mr. Allan Marnot, Swedbank Estonia and Mr. Tomas Andrejauskas, Swedbank Lithuania, for providing us with help finding our empirical sources. Also, Mr. Viikberg CFO of Estonian Lottery, Mr. Karlsson and Mr. Skogfors, Swedbank and Mr. Piho, Private Debt Fund manager in Estonia, deserve to be mentioned.

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1. Introduction

1.1 Background

The growth of capital flows to emerging markets has been a dominant feature the past decades. In particular, the rapid growth of bonds as a source of finance was one of the most widely remarked upon international developments. At the same time the traditional capital flows from banks, to emerging markets, was not attenuated (Hale, 2001).

The Baltic States is one of the emerging markets that have seen a rapid increase in growth in their economy, they have become one of the fastest developing areas in the EU during the past years. During the financial crisis the Baltic States were unfortunately not unaffected. One example is that Lithuania was experiencing a 22, 4 percent decrease in GDP in the second quarter of 2009. And the volumes of loans overdue increased sharply in Estonia most due to the corporate sector. (Liepa et al., 2009)

In the Baltics, bank loans are practically the only financial instrument used for companies in need of funding. This seems to be sub-optimal from a macroeconomic perspective, where empirical studies have shown that corporate bonds can mitigate the impact of an economic crisis. And to accelerate the rebuilding of the economy, alternative markets outside bank loans would be preferable (Hale, 2007). It is therefore relevant to investigate why the Baltics do not have a functional bond market. One proof of this - the fact that a functioning bond market is preferable - is that the companies in the Western European economies tend to finance themselves by 50 % bank loans and 50 % bonds (Marnot and Piho, 2010). So, how come we are seeing this absence in the Baltics?

1.2 Problem discussion

Alternative funding options to bank loans are extensively used in mature markets and works well. However, in the Baltic countries, funding by emitting corporate bonds is a rare element of business among firms. This is a problem for the Baltic companies because this way of funding has its advantages (for further explanation see the frame

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6 of reference part). The factors preventing the market are clearly an obstacle for further growth of the economy.

1.3 Purpose

The purpose of this paper is to investigate why there is no functional market for corporate bonds in the Baltics.

1.4 Course of action

To be able to answer our purpose we need to follow two main steps:

Step 1: We need to find and map the companies in the Baltics who are able to issue bonds. By able, they must meet some requirements in for example size and turnover. In other words, what is the potential market?

Step 2: When we have a good picture of the potential market, we must find out why the market is just potential and not in progress. What is the reason for these companies to neglect the benefits of issuing bonds as an alternative to bank loans? In order to investigate this in a solid way it is essential to understand the factors that are crucial for a bond market to function. Different characteristics of the companies, the stability in the market and the supply of other financial instruments are such factors.

In order to follow these steps, this paper will seek to answer three hypotheses. The hypotheses are presented below the frame of reference.

2. Frame of reference

2.1 About corporate bonds

Instead of - or as a complement to - bank loans, a firm can decide to issue corporate bonds. In general, a firm that is in need of capital issues corporate bonds in exchange for interest. Issuing bonds is in a way similar to taking a bank loan. When taking a bank loan, the bank is making an evaluation of the company`s ability to pay back the loan, and decide the rate of interest. When issuing bonds, the company borrows from anybody who is willing to meet the company's demanded conditions for the loan. But since every investor can’t be expected to evaluate the company in the same way as the bank do, the bond-issuing firm is provided with a credit rating from a rating institute.

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7 This rating represents the risk for investments and is a tool for the investors to evaluate if the rate of interest is proportional to the risk. The repayment period of bonds is between 1-10 years and in case of liquidation the creditor will be compensated after the banks but before the stockholders. (Roden and Lewellen, 1995 & Bolton and Freixas, 2000)

There are a number of different types of corporate bonds available for usage, below are three alternatives. The zero-coupon bond is a bond that provides the creditor with a specific date of reimbursement in terms of both interest and principal. The split coupon bonds generate lower returns in the beginning of the credit-period and higher returns later on. The payment-in-kind bonds (PIK bonds) leave the firms with an option to pay for the money lent by issuing additional securities. (Roden and Lewellen, 1995) So, what these different types of bonds have in common is that the company that borrows will pay back less or nothing in the beginning of the credit period and more or all later on.

When it comes to the conditions that companies must meet in order to be able to issue bonds successfully a certain turnover is needed. For a bond issuer on the local market in the Baltic States, a turnover that exceeds 20 million Euros per year is needed. For a company to be able to issue bonds attracting investors outside of the Baltics, the turnover should exceed 200 million Euros per year (Andrejauskas, 2010 & Marnot and Viikberg, 2010).

2.2 Issuer credit rating (Long-term): The example of Standard & poor

Just as for private persons, when a company wants to borrow money, the lender/investor wants information about the companies’ ability to pay back the loan. This information is the basis for agreeing to invest, and to decide what the rate of interest will be. Therefore, a company that wants to issue bonds will benefit from having a credit rating to provide investors with a trustworthy and standardized evaluation of the company’s creditworthiness. A low credit rating is typically connected to a high rate of interest while a high rating means higher security and thus a lower rate of interest (Standard & Poor, 2009).

There are many actors on the market providing credit ratings for investors to take part of before e.g., deciding to invest in corporate bonds. In order to provide an

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8 understanding of how these ratings work, below is a description of how one of the largest rating institutes - Standard & Poor (S&P) – work.

S & P looks at how likely the companies investigated are to be able to pay for their bond obligations by looking at the numbers of the companies, the history of the companies, and by looking at how reliant the companies are upon their environment. For example, a company can be considered solid because of continuous profits the past years, but it could still be assigned a weak "grade". This is because S & P believes that if the environment around the firm changes in a negative way in the coming ten years, the firm won't be able to pay for itself. The grading of obligors range from AAA to D/ SD/ R and the range is quite wide as AAA is followed by AA, and so on. In addition, the ratings are even further diversified. Each of these ratings – between AA to CC – can come with either a plus or a minus or neither. This implies that there are 25 different grades which of 10 are considered investment friendly grades, 12 Significant speculative and three below speculative. (Ibid.) For specific ratings and their meanings see attachment 2.

S & P's and other rating institutes also provide these ratings for sovereign states such as local and regional government. The rating for an entire country somewhat gives a hint about the creditworthiness on the market. For example, the Baltic countries have considerably low credit ratings compared to Sweden, which is considered to be a stable environment. (Standard & Poor, 2010)

2.3 Why bonds?

2.3.1 In order to win time and expand uninterrupted

Basically, a firm wins time by issuing bonds. The firm will not have to pay equally high (or higher if they amortize) rates of interest each year. Instead, the firms will either pay only one sum in the end of the credit period or smaller sums in the beginning. So, if the firm is growing quicker than the general market firms will benefit from giving out these forms of securities over taking a bank loan due to the postponement of payments (Roden and Lewellen, 1995).

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9 2.3.2 Because relying on banks only is a risky tactic

Bank loans also carry covenants that allow banks to discontinue their financing on relatively short notice, something that makes liquidity crises more likely, especially in emerging markets (Dooley, 2000).

Harwood (2000, p.48-50) describes Dooley’s reasoning in a more throughout way. She means that a well functioning bond market has the advantage of matching creditors with firms in a tailored way. What she means with this is that one major risk with bank loans is that short-term capital often is matched with long-term projects. As the short-term capital moves away, the long-term projects are left unfinished. So, for a firm it is beneficial to have a diversified supply base of capital.

2.3.3 Because generally there are higher costs of bank loans

The close contacts that banks must have with their clients in order to secure their investments cost a lot of time and money. In addition, they will also have to secure profits. These intermediation costs will make themselves heard by the clients of the banks in terms of spreads. (Bolton and Freixas, 2010) The interesting thing about this is that as these spreads of the banks increases, firms tend to switch towards a financing strategy that emphasizes bonds (Kashyap et al., 1993). However, all firms do not have the necessary qualifications. Diamond (1994) concludes that as the intermediation costs of banks rises (consequently rising the costs of the lending firms), only the firms possessing the necessary qualifications can shift towards financing themselves by issuing bonds, that is firms that are mature, large, and considered safe.

2.3.4 In order to circumvent major crisis impacts

Another important aspect related to this subject has to do with crises. When a country is experiencing a crisis the risk associated with lending money to companies within that country rises. Accordingly, the interest rate does the same. When a crisis hit a developed economy the rates do not rise that much, but when a crisis hit a developing country the interest rate may rise significantly over a night. With a funding agreement stretching over ten years many of these “booms” can be circumvented. Companies can decide to rely on fixed interest rates from banks but this is generally costly. Another option is to issue long-term bonds. This is not only good because companies secure their long term funding at a fixed rate of interest, but stable companies may

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10 also be able to go around the high base interest that the central banks charge in times characterized by uncertainty on the market. These rates of base interest are often disproportional in developing countries during crises and Harwood stresses that bonds is a good way around this. (Harwood, 2000, p. 48-50 & 54-56)

2.4 Bonds, firm type, and bond-threats

Bolton and Freixas (2000) stresses the fact that firm type in much decides the financing. They conclude that firms that are mature, large, and considered safe will choose to finance themselves mainly by issuing bonds. Start-up-firms and more risky ventures will on the other hand be likely to finance themselves through the banks. The main reason for these occurrences stated by the author is that bank loans, in one sense, are more flexible. This is because the fact that if a bond-payment is not completed on the stated date the firm will have to declare bankruptcy. If a firm fails to pay for its bank loans however, the bank will put the firm under surveillance but the business will be able to live on. This is the main benefit with bank loans: banks do not liquidate "good" firms; they will only liquidate firms that they judge as having no potential delivering in the future.

2.5 The hypotheses

In order for us to further investigate why the market of corporate bonds is not as developed in the Baltics as it is in more mature markets, this paper will seek to answer the following hypotheses concerning "why?" in order to reach a conclusion.

First of all we will have to make sure that there really is a potential in the Baltic market for corporate bonds. We will have to decide whether the companies really do meet the demands related to turnover; because if the companies in general are not large enough that would explain a lot.

Hypothesis 1: There is no potential market in terms of bond issuers in the Baltics.

When issuing bonds, a company benefits from having some kind of credit rating. The process of being rated is expensive which might be an obstacle for companies that in other cases would have been issuing bonds. Assuming that a company is rated, the second question is what the rating will be. Internal factors such as company history and numbers have influence on a company’s credit rating. But the credit rating is also

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11 affected by the company’s environment. The Baltic States is a lower rated “environment” compared to for example the Scandinavian countries. (Euromoney) This will probably have the effect that a Baltic company has a lower credit rating than a similar country in one of the Scandinavian countries. A low rating does not necessarily mean that a company cannot issue bonds, as for other financial instruments a low rating or high risks for investors are simply connected to a high yield. But on the other hand, if the companies are not rated high enough, there are two main barriers for issuing bonds. Investors would demand a yield that is too high and would make funding through bonds too costly. In addition, the company must be confident that they will be able to pay back to the investors in order to avoid bankruptcy. This leads us to our second hypothesis:

Hypothesis 2: The credit ratings of the Baltic companies are too poor to support an issue of bonds. Alternatively, there are no credit ratings available for

creditors.

Finally, looking at the theory described above; there are various benefits for a company to issue bonds. The main reasons are described below:

To enable a fast growth: If a company grows faster than the market average it will

benefit from paying less in the beginning hence being able to translate the borrowed money in to more money instead of paying interest each year.

To avoid the surveillance and intermediation costs of banks: This is especially true for

large firms that are considered to be safe. They can normally receive a lower rate of interest from the public since investments in these firms are considered to be solid, in extreme cases as solid as state bonds.

In order for companies to spread their risks: If a bank goes bankrupt the financing

will disappear. The bond money will be at the disposal of the firms for the chosen period.

These benefits suggest that Baltic companies would issue bonds as a part of their funding strategy, but however, each specific type of funding a company has its benefits and drawbacks. Looking at a financial instrument as any other kind of product would imply that each instrument is a substitute for another one. If the benefits of the substitute are superior to a product, the product will not be sold. In the

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12 case with issuing bonds, one substitute is for the companies to take bank loans. If the terms for bank loans in the Baltics are cheaper and more beneficial than issuing bonds, there will be no incitements for a company to issue bonds. Our third and last hypothesis will therefore be:

Hypothesis 3: Due to specific market conditions in the Baltics, issuing bonds is not preferable compared to other financial instruments.

3. Method

3.1 Choice of method

This paper examining the Baltic market for corporate bonds is primarily based on a quantitative research but both quantitative and qualitative sources are used in a multiple method study. The reason for relying primarily on quantitative sources is basically that it is most suited in order to provide a basis for answering the hypotheses since we had to gather information about a whole market and analyze a great amount of numerical data. First of all, access to the information needed in order to perform a quantitative study of our problem is available via public sources. Secondly, a quantitative method enabled us to perform measurements of different variables, for example mean value and median and to display the results statistically with graphs or tables. (Lewis et al., 2009)

The quantitative study could provide us with a good view of the three hypotheses. We were able to map the companies in the market, search for ratings and investigate their different rate of interests for bank loans versus bonds. But to further analyze the hypotheses, and to investigate if other factors had impact for our problem, we had to have a closer look. Hence, the qualitative research worked as a solid complement while analyzing the rest of the hypotheses. As suggested by Lewis et al. (2009), we therefore used a multiple method where we combined the quantitative method with also gathering and analyzing qualitative data.

The next step was to interview key persons with substantial knowledge of the Baltic market. The decision fell on e-mail- and phone interviews with experts in the Baltics. The primary advantage with the e-mail interviews were that during a series of e-mails,

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13 we could reflect on prior responses and therefore be able to sort out what was relevant. This is in line with the recommendations of Lewis et al. (2009). The e-mail interviews led to a videoconference in order to further discuss the relevant issues in a more extended way. The videoconferences and telephone interviews with experts in the markets gave us enhanced information and help with contacts to people in our target companies.

Later on a questionnaire was sent over e-mail to the ones accountable for financing structure in the target companies. Even though questionnaires are not the best method to seek answers to open ended questions (Ibid.), we saw them as a useful complement in the multiple method research. The questionnaire was designed to leave as little room for misinterpretations of the questions as possible. The full questionnaire can be found in attachment 3. The reason for not doing the interviews face to face was of practical nature, a sufficient number of meetings with responsible persons in the Baltics would have required more time consuming traveling than we were able to perform within this study.

In our search for qualitative input from the companies we received 16 e-mail addresses to persons accountable for financing decisions in the target companies. We received these e-mail addresses during our videoconferences and the questionnaire was sent to persons accountable for the financing decisions in the companies. As it turned out, we only received three answers. This might seem scarce and more answers would have improved the credibility of our results. If we had built our conclusions on solely qualitative information, the answers from the experts and only three companies would have been an insufficient foundation. Fortunately, this is not the case. As mentioned before we used a multiple method and the quantitative research is the primary source of information. This quantitative research provided numbers for basically the whole market, and the qualitative sources are used as a tool to interpret and understand these numbers. When we received answers from our qualitative sources that we could confirm with numbers from the quantitative study, we consider this information to be trustworthy. We do not claim that we can draw conclusions about every single Baltic company from the responses. However, we can make the assumption that it is very likely that the conclusions we can draw from our sample is in general a good description of the Baltic bonds market.

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14 3.2 Defining our sample

Although we assumed that the Baltic market contained a limited number of potential bond issuers, we still needed to define some criteria for selecting our sample from the broader population of Baltic companies. What we were looking for here were mainly companies that were large enough in terms of turnover to be able to issue bonds. As mentioned a certain turnover is needed for a company to be interesting for our study. For a bond issuer on the local market, a turnover that exceeds 20 million Euros per year is needed. For a company to be able to issue bonds attracting investors outside of the Baltics, the turnover should exceed 200 million Euros per year. (Andrejauskas, 2010 & Marnot and Viikberg, 2010) This implies that every Baltic company with a turnover exceeding 20 million Euro is of interest for our study. We also noted if the turnover exceeded 200 million Euros. This provided us with two types of potential bond issuers, the ones for the local market and those who can become international actors.

3.3 Finding our sample (Including limitations)

Finding these companies was mainly done in the Baltic stock exchange's main- and secondary lists (Nasdaqomxbaltic). All listed companies are accounted for in these lists and have their annual reports available via the stock exchange's web page. The hard part was finding un-listed, non-public companies. We decided to limit our search for unlisted companies to the Baltic ones that were listed among the top 500 companies in Eastern- and central Europe by Deloitte (2010). Some of these companies do not display any numbers at all while others do. The ones that did (6 out of 14), have been covered and the numbers have been gained via their web pages. In addition, we decided to include the major airlines of the Baltic States (Air Baltic and Estonian airlines) since these also were large enough in terms of turn over.

So, finding our sample has mainly been done by searching through the Baltic stock exchange's lists and company web pages for companies with a sufficient turnover. The numbers have been translated from domestic currency in to Euros using historical exchange rate data from oanda.com.

Since we will put bank loans and bonds against each other, we decided to not cover the banks and financial institutions in the study. This will give us a more accurate picture of how the companies choose to finance themselves either through banks or

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15 directly in the market. The borrowings of financial institutions simply go beyond the scope of this research since they tend to loan from national banks and private persons.

To get a better insight into the market for bonds we have decided to look at the bonds issued with a maturity date after 2007, in other words, we look at how many companies there are that have been issuing bonds during the last two years 2008-2009. This gives us a more accurate picture of how many active companies there has been on the market in recent years. If we had just studied the latest reports, most of the active companies had not been included as their bonds had a maturity date before 2009. Now, we get a better view of how many companies there are that are – and that recently have been - active on the market.

3.4 Testing the hypotheses

We have been using our sample to test the hypotheses to why there is no functional market of Bonds in the Baltics. The outcome of the first hypothesis is essential for the continuation of the study with the following hypotheses. But besides from that first one, the hypotheses could be examined independently of the outcome from the other ones. It is important to bear in mind that the reason that the Baltics do not have a functional bond market does not necessarily depend on one factor alone. Therefore, if one of the hypotheses is true, the other ones must still be examined. The results from the quantitative research were discussed for each hypothesis during e-mail interviews and the videoconference in order to strengthen the reliability of the results with a multiple method survey. Below is described how we examined the different hypotheses.

1. There is no potential market in terms of bond issuers in the Baltics.

This hypothesis was basically depending on if we found a sample of companies with a sufficient turnover or not. How large a potential market would be is of course of interest when analyzing why there is no functional market in the Baltics. If for example there are just a few companies meeting the criteria, they might even be issuing bonds already but their numbers are so small that they are not noticed. Anyway, no matter the size of a potential sample, if we found a sample of companies meeting the criteria, we intended to consider it a potential market worthy of being tested.

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16 2. The credit ratings of the Baltic companies are too poor to support an issue of bonds. Alternatively, there are no credit ratings available for creditors.

Finding an answer to this hypothesis meant that we had to start by looking at credit rating institutions searching for rated Baltic companies. Unfortunately, there was a lack of information available for us to provide a complete view of rated Baltic companies for 2010. However, information from 2008 could provide us with a better picture and we use this information in our quantitative research. Still, due to this lack of information we found about credit ratings of Baltic companies, a qualitative approach to this question was needed. The issue was discussed during the e-mail interviews and the videoconference and the Baltic States national ratings were also considered as a comparison.

3. Due to specific market conditions in the Baltics, issuing bonds is not preferable compared to other financial instruments.

If the terms for bank loans are cheaper and more beneficial than issuing bonds, there will be fewer incitements for a company to issue bonds. Therefore we compared the terms for bank loan with the cost for issuing bonds. The terms for bank loans has been calculated from numbers found in annual reports. Dividing the cost of loans with the total amount of loans a company declared in its annual report gave us approximate interest rates and cost of bank loans for Baltic companies where the interest rates are not stated. However, the interest rates were most often stated in the reports and so were the rates of the bonds.

Comparing this with the present terms of issuing bonds gave us an answer to which financing option that was the cheapest one. However, in order to understand which of the financing options that could be considered the most preferable one, we had to go further and look at the big picture. Here qualitative input gathered from the questionnaires, the videoconferences, and the annual reports helped us understand the weaknesses and strength that companies put against each other in their search after a preferable funding structure.

3.5 General threats against the reliability and validity of the study

Obviously, the financial crisis has had a great impact on the Baltic economy. Examining this market with the crisis still affecting the market might imply some

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17 methodological problems. It might be hard to decide if a specific feature of this market situation is typical for an emerging market or for a market struck by a financial crisis. For example, even normally reliable companies might go bankrupt in a financial crisis. However, the focus is on looking at the situation today and identifying what obstacles is in the way for a functional bond market. If these obstacles are a result of the crisis or not, they are still preventing the market and should not be neglected, no matter of their origin. It might be the case that radical changes might occur in the market when the crisis is definitely over and the market have recovered, but as said before, this is a study of the situation today and not a vision of the future.

In addition, many of our results are based on interviews of only four experts on the subject. From one angle this might seem scarce. However, we mean that the titles and experience of these sources makes it possible to draw conclusions from their statements.

4. Empirics/Analysis

4.1 Hypothesis 1: There is no potential market in terms of bond issuers in the Baltics.

As indicated by table 1 below there were 56 companies out of the studied 89 that could be classified as having potential for issuing bonds (with potential tied to turnover) but only six of them had outstanding bonds 2008/2009. (Attachment 1)

Baltic Main List 34

Baltic Secondary List 47

Unlisted Comapanies 8

Total 89

Companies potential for national bonds 40

Companies potential for international bonds 16

Firms without potential to issue bonds 33

Total 89

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18 These numbers shows that there clearly is a market for corporate bonds in the Baltics. The market is not overwhelmingly big but still, there are 56 potential companies where among only six companies are/ have been using bonds as a funding source in 2008/2009.

(EUR ´000)

Number of companies 40

Percent of total companies studied 45%

Lowest turnover 20364

Highest turnover 180216

Average turnover 75945

Median Turnover 68703

Table 2. Potential firms on the national bond markets (Source: Attachment 1)

As shown by table two the major part of the potential firms have the potential of issuing bonds only on their home market. 40 out of 56 potential firms declares a turnover above 20 000 thousand Euros but below 200 000 t Euros.

(EUR ´000)

Number of companies 16

Percent of total companies studied 18%

Lowest turnover 203316

Highest turnover 2235379

Average turnover 525967

Median Turnover 336782

Table 3. Potential firms on the international bond market (Source: Attachment 1) The Baltic companies that - in relation to their turnover - have the potential of issuing bonds also to the international market are as indicated above rather scarce. Only 16 companies meet the demand of a turnover exceeding 200 000 t Euros.

(EUR´000) Financial Liabilities Potential bond market

National Group 1386040 693020

International Group 5081317 2540658

Total 6467357 3233678

Table 4. The potential market for corporate bonds in The Baltic States in numbers (Source: Attachment 1)

If we are to translate how large the market is for corporate bonds in terms of money using Mr. Marnot and Mr. Piho's (2010) statement that companies in Western Europe fund themselves by using 50 % bonds, the market in the Baltic States ads up to 3,2 Billion Euros, so the market for corporate bonds is rather substantial.

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19 So, we can conclude that there clearly is a market potential for corporate bonds in the Baltic States. We can also conclude that the potential is remarkably above the existing market. The question is "why?" and the answers will reveal as we continue straitening out the question marks surrounding our other hypotheses.

4.2 Hypothesis 2: The credit ratings of the Baltic companies are too poor to support an issue of bonds. Alternatively, there are no credit ratings available for creditors.

This hypothesis is supported by the fact that only two, Lietuvos Energija and Eesti Energia, out of 56 companies with a potential to issue bonds had a credit rating. (Standard & Poor’s, 2008) There are a few other Baltic companies with a credit

rating, but they are not included in this study since they are banks and financial institutions, which are excluded from our sample. This result could then at first glance be interpreted as if only the two companies who have a rating are able to issue bonds. For the international market, this might be true and a limit when a credit rating is needed if a company desires to attract investors from abroad. For the domestic market however, this result might be of less importance than what we could at first suspect.

During the e-mail interviews and the videoconference, the experts about the market refused the importance of the lack of ratings in the market. The experts meant that credit ratings were not a major factor of importance in the Baltic market, and that the rating institutes reputation is not as highly valued as we suspected. This has different explanations. One explanation is the cost of becoming rated, this cost is not solely in monetary terms but also time consuming and complicated (Andrejauskas, 2010). Furthermore, this cost might also be hard to motivate if the companies suspect that the rating will be low.

Considering the low ratings of the Baltic States compared to for example the Scandinavian countries (Estonia is rated highest with an A, while Latvia has BB+ and Lithuania has BBB compared to Sweden's AAA (Standard & Poor, 2010), the Baltic companies cannot expect to receive a favorable rating. (Andrejauskas, 2010 & Marnot and Viikberg, 2010) This information was not unexpected to us. The fact that ratings are costly and that Baltic ratings would not be very favorable was something we

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20 suspected to be a potential reason resulting in that we would find very few rated companies. More surprising was however the view on ratings from Baltic investors and how a bond transaction can be performed in the Baltics. The Baltic investors do not require a local company to be rated for them to invest. Instead, the investors perform a separate evaluation of the company (Marnot & Viikberg, 2010). This evaluation is performed via a close interaction between lender and investor and make up for the absence of a credit rating from the investors’ side. The local bond market is characterized by personal contacts and cooperation between lender and investor, which decrease the importance of credit ratings from large rating institutes (Ibid.). With this in mind, we can see the lack of rated Baltic companies and the low sovereign rating of the Baltic States as an obstacle to the market of Baltic bonds for the international market. For the local market however, the lack of ratings seems to be of minor importance for the trade of bonds.

4.3 Hypothesis 3: Due to specific market conditions in the Baltics, issuing bonds is not preferable compared to other financial instruments.

In order to discuss this hypothesis let us start by looking at tables four and five.

Median 3,71%

Lowest 1,24%

Highest 6,36%

Table 4. Interest rate on bank loans (Source: Attachment 1)

As presented in table four above, the bank loans in the Baltic countries are significantly low in general. With a median loan rate of 3, 71 %, bank loans are significantly cheaper in terms of interest rate compared to bonds, which have a median interest rate of 7, 51%.

Median 7,51%

Lowest 4,06%

Highest 12,20%

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21 In fact, to finance a company in the Baltic States by bonds (remember: without intermediaries this way of financing should be cheaper than bank loans (Bolton and Freixas, 2010) will cost more than twice as much than financing by bank loans. Of course, we haven't found a large number of companies financing themselves with bonds, so these numbers should be looked at conservatively. With this in mind we can assume that the low interest rates of banks are actually crowding out bond financing since the lowest interest rate for bonds (4,06 %) actually is higher than the median rate of interest for bank loans (3,71 %). This assumption was also supported by Mr. Marnot and Mr. Piho (2010) during the videoconference

AS ekspress grupp, an Estonian company involved in publishing, states that they are not using bonds, but the reasons for this are actually diverse and take more parameters in to account than just the interest rate. First of all AS ekspress grupp states that it is easier to re-negotiate the terms and conditions of a loan if you deal with a bank (Raidma, 2010). This can be interpreted as a reverse way of securing a fair rate of interest. The reason for this is that if a company decides to issue bonds over a long-term period the interest rate will remain the same in good- and in bad times. In a setting - like the Baltics - where few companies use bonds, the ones that do are actually the risk-taking one since other companies will have interest rates that relates to the surrounding economy. If times are good and the interest of bank loans are high, then companies will pay high rates while earning more. If times are worse and the interest rates of bank loans are low, the companies will pay less for their loans and make less money. On the other hand, a company that rely on bonds will take a step outside this circle and benefit even more during good times when they will make more money and have a fixed rate of interest. Although, when the premises are the opposite - in times characterized by crisis - the companies that rely on bonds will still have a relatively high cost of capital in a market where profits are lower. So, companies in these kinds of markets tend to be rather short-term oriented. This is supported by Mr. Marnot and Mr. Piho (2010) who states that the companies in the Baltic States are rather short sighted in their decision making.

Regardless of the above, AS ekspress grupp states that if the bonds would prove to be a cheaper way of financing than bank loans, bonds would be of higher interest. However, they state that they think that it would be difficult to find investors on the local market. They continue by adding that entering the international market would

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22 mean additional costs for marketing etc. (Raidma, 2010) This view is supported by Mr. Marnot and Mr. Piho (2010) who claims that a domestic (Baltic) market of investors for corporate bonds still is not present.

So, we have a few things that tend to favor taking on bank loans rather than issuing corporate bonds in the Baltic States. First of all, the interest rate is remarkably lower for loans. Secondly, the risk factor is reverse in these countries; the companies that decide to rely on a fixed, long-term interest rate are the ones taking the real risk. Thirdly, since the home markets do not provide investors, companies will have to rely on the international market; this is often a costly alternative. Within the costs for marketing mentioned in regards to issuing international bonds a significant share can probably be tied to getting a rating from the big credit rating institutions.

In regards to the above it seems surprising that any company in the Baltic States would decide to issue corporate bonds but still, some do. Let's have a look at two of the companies that decided to use corporate bonds as a way of financing and look at the presented reasons.

Eesti energia, a state owned Energy Company in Estonia, have decided to issue bonds for the international market. The reasons are foremost two folded. First of all, Eesti energia states that they would like to minimize their liquidity risk. They do this by using multiple sources of capital, there among bonds. (Eesti Energia, Annual report 2004/2005, p. 57) In addition, they tend to think from an opposite angle than the mainstream Baltic companies when it comes to their view upon floating and fixed rates of interest. Eesti energia sees a great risk involved with floating interest rates. Hence, they have a company standard stating that over 50 % of their loans should come with a fixed rate of interest (Eesti Energia, Annual report 2009/2010, p. 111). As indicated by attachment 61 and their annual reports they choose to rely on international corporate bonds in this strive after fixed rates. Actually, in the end of 2009 as much as 91 % of the company's loans had a fixed rate of interest, and bonds accounted for close to all of the fixed-rate financing. This is extra interesting as we can conclude that the interest rates of the bonds was as high as 4,9 %. This can be

1_{Attachment 6 covers the numbers concerning all investigated companies. It can be obtained}

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23 compared to the interest rate of the bank loans that the company had which were as low as 2,5 %. (Attachment 6)

Linas agro group, a Lithuanian agro company that had bonds in the past up to 2008, states that what made bonds appealing for them was mainly the enhanced flexibility. Further on, they state that this flexibility comes from the lack of annual collateral requirements. The downsides are said to be a demanding process behind issuing the bonds and a higher interest rate. The company has decided to give up bonds but states that if the interest rate of their bonds were in line with their bank loan rate this would make bonds interesting. (Tumenas, 2010)

So, it seems as if Eesti energia have decided that it is too risky to rely on one source of capital. This is in accordance with what Dooley (2000) stresses when he reasons that bank loans are rather risky as they carry covenants that allow banks to discontinue their financing on relatively short notice. Dooley (2000) mean that this is something that makes liquidity crises more likely, especially in emerging markets. In addition, Eesti energia wish to be able to form their activities after a known interest rate. The sentence " In order to finance an extensive capital investment program, the Group has issued a 7-year international bond in the amount of 200 million euros and signed two 15-year loan agreements in the amount of 150 million euros." (Eesti Energia, Annual report 2004/2005 p. 57) also hints of an understanding of matching the right funding with the right projects. As long-term projects emerge, the company wishes to match these with long-term financing. This is in line with what Harwood (2000, p.48-50) described when reasoning around the fact that too many projects disappear because of the fact that long-term projects are financed by short-term capital. Further on, (Harwood 2000, p. 48-50 & 54-56) stresses that, in general, as a crisis emerges in developing economies the interest rates can become disproportionably which favors fixed interest rates. Even this has probably been taken in to account by Eesti energia as they rely on 91 % fixed-rate loaning. Linas agro group did not mention any of the reasons mentioned by Eesti energia. The focus for them was clearly on flexibility.

So, do specific market conditions in the Baltics make issuing bonds non- preferable compared to other financial instruments? If we look at the interest rates of bank loans and bonds this clearly favors that bank loans should crowd out bonds. Furthermore,

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24 the fact that only six out of the 89 companies investigated (Attachment 1) had outstanding bonds in 2008 or 2009 further supports this view. On the other hand, six companies out of 89 have decided to issue bonds regardless of this. It seems as if these companies find bonds preferable regardless of the higher rate of interest and looking at the example of Eesti energia the major reason for relying on bonds despite the higher costs has to do with the safety aspect involved with a set rate of interest. In fact, Eesti energia had - as the only company examined - outstanding bonds in 2004. The interest rate of bonds was close to the double of their bank loans even then but they decided to go with bonds and haven't looked back since (Attachment 6). The answers from AS ekspress grupp show another aspect of this. This company stresses the fact that it is not safe, but rather risky to rely on a set rate of interest. On the other hand they state that they would be interested in issuing bonds if the interest rate was favorable.

Since Eesti energia finds it reasonable to rely on bonds despite the higher costs perhaps more companies in the Baltic States should feel the same way. What really speaks for this is that Eesti energia have been taking all the factors in to account in a more throughout way than other companies. When you look at the answers from companies that are not using corporate bonds they do not mention any of the main advantages with bonds, the focus tend to be on the interest rate (Raidma, 2010 & Tumenas, 2010); this implies that perhaps the companies do not really make their choices considering all the advantages with bonds. This can be a result of the mentioned short-term orientation that Baltic companies have: what is interesting is the interest rate that the company receives for now and long-term aspects are neglected. Another reason is as mentioned that the companies know about the advantages but that they see them as disadvantages since it may seem risky to take a step away from the changing market conditions relying on fixed interest.

Lietuvos energija states that although they had bonds only two years ago they would need to renew their knowledge (Grondskis, 2010). On the other hand, this lack of interest is probably resulting from a conviction that bonds are not the preferable alternative for them in the market of today. To draw the conclusion that only Eesti energia have realized the benefits from issuing bonds is probably not a correct judgement. One thing that favors the stand point that the general idea of Baltic companies is that the downsides of bonds outweigh the benefits is that the number of

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25 companies using bonds has dropped from six companies in 2008 to two companies in 2009. This change shows that there has been active decision making involved in the choices of financing and that the decision was that the downsides of bonds were super ordinate the benefits. It is not easy to draw general conclusions from these facts. What we can conclude is that the interest rates of bank loans are lower than the interest rates of bonds and that some companies still choose to issue bonds but that the majority does not. Moreover, we can also suspect that if the interest rate of bonds were to be lower than those of the banks loans - or the same - then companies would probably be more interested since some use this way of financing regardless of the higher costs.

5. Conclusions and end discussion

To begin with, we can conclude that there is a potential market for corporate bonds in the Baltic countries. The total number of companies amount to 56 out of 89, looking at all listed companies and the largest un-listed ones with public material available. However, as of today, only two out of these 56 are using bonds, so the potential is substantial. 40 out of these 56 companies can in terms of turnover be characterized as having the potential for issuing bonds to the national (Baltic) market and 16 also to an international market.

A problem with the above is that there seem to be a lack of investors in the local Baltic markets. If companies due to this situation seek investors on the international market this causes further problems. First of all, in order to issue bonds to the international market the companies must first of all receive a credit rating. The rating in much decides the final interest rate, so a favourable rating is important. To receive a rating is however a time consuming process and the ratings of the Baltic companies are expected to be low. The low expectancies can be tied to the environment in which these companies work. Company ratings are often closely related to the local market of the companies and the Baltic countries are rated in the lower end of the spectrum. The advantage is that the (few) Baltic investors in the local market typically do not demand a credit rating to invest in a company. Therefore, for Baltic companies aiming for the international bond market, the lack of credit ratings is a problem. But for the local market, this is of minor importance.

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26 The most important aspect in explaining this dysfunctional bond market is the low interest rates of bank loans that are present in the Baltics. These have been low for a long time and the interest rates for bank loans were lower than those of bonds even back in 2004 for the Estonian energy company Eesti energia that was the only company that used bonds during that time. Today, the median rate of interest of

3,71 % for bank loans is crowding out the use of corporate bonds, which is at a median rate of 7,51 %.

Although companies mention the interest rate as the largest disadvantage with bonds it does not end there. In addition to what has been mentioned above we also have the disadvantage of bonds being more complex than bank loans. Another important thing is that the Baltic market conditions actually are turning what would be considered to be advantages in other markets into disadvantages. The flexibility of bonds in the sense that the companies have the money at their disposal for a set period of time without any intermediation and payoffs have actually developed into a disadvantage in the Baltics; and it all boils down to the short sightedness of Baltic business. Firms in the Baltic States seem to favour a loaning strategy where e.g., renegotiations of the terms are present. Flexibility, for the majority of the Baltic enterprises, do not seem to be being able to work uninterrupted knowing what the interest rate is today, and will be tomorrow. Instead, flexibility in this shortsighted environment is defined as being able to follow the rest of the market. It seems as if it becomes a more risky strategy to rely on a fixed rate of interest - as in the case with corporate bonds - as the majority relies on a floating one. The reason for this is that if a Baltic company decides to rely on a fixed interest rate over the years to come that company takes a step away from the surrounding market. If the sales figures drop - as in the case in times characterized by crisis - the companies will still have to pay an equal amount for their funding. Hence, companies will in these times experience a relative loss in comparison with the other companies in the market, as they will not be included in market stimulations such as lower interest rates.

Our conclusion is that in order for corporate bonds to become a frequently used funding source in the Baltic States, leaders of the companies must become more long-sighted concerning their financing strategy. Secondly, the interest rates of the bank loans must be in line with the one companies receive as they issue bonds. If the

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27 interest rates on bank loans continue to be half of what companies receive by issuing bonds very few will take the leap and change their financing strategy.

6. Suggestions for future research

Since this study was rather limited in regards to it being performed during an effecting finance crisis it would be interesting to see what future research would conclude on the subject in a setting were the market is at normal mode. If the interest rates of the banks reach a more normal level a few years from now it would be meaningful to see whether the companies become more tempted to issue bonds. In other words this would help answering the question concerning what is the most important obstacle for a bond market in the Baltic States: the short sightedness or the interest rates of bank loans?

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28

7. Sources

7.1 Printed sources

Bolton, P. & Freixas, X. "Equity, Bonds, and Bank Debt: Capital Structure and Financial Market Equilibrium Under Asymmetric Information", Journal of Political

Economy. April 2000, vol. 108, issue 2, pp. 324-351.

Covitz, D. & Dowing, C. “Liquidity or Credit Risk? The Determinants of Very Short-Term Corporate Yield Spreads”. Journal of Finance, October 2007, vol. 62, issue 5, pp. 2301-2328.

Diamond, D. "Corporate capital structure: The control roles of bank and public debt with taxes and costly bankruptcy", Economic Quarterly (10697225). Spring 1994, vol. 80, Issue 2 pp. 11-37.

Dooley, M “International financial architecture and strategic default: can output losses following international financial crises be avoided” Carnegie-Rochester Conference

Series, 2000, vol. 53, Issue 1 pp.361-.

Hale, G. “Bonds or Loans? The Effect of Macroeconomic Fundamentals” The

economic Journal, January 2007, vol. 117, Issue 516, pp. 196-215.

Hale, G. ”Bonds or Loans? On the Choice of International Debt Instrument by Emerging Market Borrowers” mimeo, UC Berkeley, 2001.

Harwood, A. “Building local bond markets an Asian perspective”. International finance corporation, Washington D.C., 2000.

Kashyap, A. Stein, J. Wilcox, D. "Monetary policy and credit conditions: Evidence from the composition of external finance", American Economic Review, March 1993, vol. 83, issue 1 pp. 78-98.

Kozhemiakin, A. ”The Risk Premium of Corporate Bonds”. Journal of Portfolio

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29 Lewis, M., Saunders, M. & Thornhill A. "Research methods for business students", 5th edition. Pearson education limited. 2009.

Longstaff, F. A.; Mithal, S. & Neis, E. “Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market”. Journal of

Finance, October 2005, vol. 60, Issue 5, pp. 2213-2253.

Roden, D, Lewellen, W. "Corporate Capital Structure Decisions: Evidence from Leveraged Buyouts". FM: The Journal of the Financial Management Association, summer 1995, vol. 24, issue 2, pp. 76-87.

Liepa, L., Rymeikis, T. & Sidorenko, N. ”Dealing with the downturn”. International

Financial Law Review. October 2009, pp. 15-18.

7.2 Electronic sources

Deloitte, "CE top 500", 2010, http://www.deloitte.com/cetop500

Available online 2011-01-10

Eesti Energia, Annual report 2004/2005,

https://www.energia.ee/c/document_library/get_file?uuid=77bd000e-43f3-42b4-8d04-7c531599c59b&groupId=10187

Eesti Energia, Annual report 2009/2010,

https://www.energia.ee/c/document_library/get_file?uuid=45d94e92-99ec-442a-a41a-69de7d766245&groupId=10187 Available online 2011-01-10 Nasdaqomxbaltic, http://www.nasdaqomxbaltic.com/index.php?id=3790857 Available online 2011-01-10 Oanda, http://www.oanda.com/lang/sv/currency/historical-rates Available online 2011-01-10

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30 Standard & Poor , "Nordic and Baltic ratings", 2008.

http://feed.ne.cision.com/wpyfs/00/00/00/00/00/0D/8F/1B/wkr0009.pdf

Standard & Poor, "Understanding Standard & Poor's rating definitions", 2009, http://www2.standardandpoors.com/spf/pdf/media/understanding_ratings_definitions. pdf

Standard & Poor, "Sovereign Ratings", 2010,

http://www.standardandpoors.com/ratings/sovereigns/ratings-list/en/us/?sectorName=null&subSectorCode=&filter=L

7.3 Interviews

Andrejauskas, T., Head of DCM Baltics, Swedbank Lithuania. Telephone interview, 02-11-2010 & 20-11-2010.

Grondskis, D., Director of Admistration,AB Lietuvos energija, E-mail questionnaire, 2010.

Marnot, A., Baltic equity capital market, Swedbank Estonia & Viikberg, C., CFO of Estonian Lottery. Video conference, 02-12-2010 12:00-13:30.

Marnot, A., Baltic equity capital market, Swedbank Estonia & Piho, P., Private debt fund manager in Estonia. Video conference, 02-12-2010 13:30-15:00.

Raidma, P., CFO, AS Ekspress Grupp, E-mail questionnaire, 2010.

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31

8. Attachments

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32 8.2 Attachment 2: The different ratings of Standard & Poor and their meanings

Investment friendly

AAA: This is the highest possible rating. The obligor will most certainly have no problems answering to its financial commitments.

AA: These obligors show only a slight decrease in commitment potential compared to the above.

A: These players are trustworthy but more dependent upon environmental conditions than obligors included in the categories above.

BBB: These players have an acceptably high potential to answer to their financial commitments but are more dependent upon environmental conditions than players included in the AAA and AA categories.

Significant speculative characteristics

BB: These players are not as vulnerable in the short-term as other obligors in the lower end of the spectrum. However, these players are surrounded by-/ involved in critical uncertainties and conditions which could affect their capacity to answer to their financial commitments.

B: These actors have – at the moment – no problems answering to their financial commitments. However, they are more vulnerable than the 'BB'-rated. In addition, these players are surrounded by-/ involved in critical uncertainties and conditions

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33 which are likely to affect their capacity or willingness to answer to their financial commitments.

CCC: These obligators are rated as being currently vulnerable to non-payment. They are even rated to be in need of certain conditions in order to be able to answer to commitments of the financial nature.

CC: These players are rated as being currently highly vulnerable to non-payment.

R, SD & D: Players rated as belonging to these categories are simplified either under financial supervision, or has failed to pay financial obligations, or are – according to S & P – likely to lack the ability to pay their financial obligations.

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34 8.3 Attachment 3: Question sheet sent out to financial leaders of Baltic

companies in the e-mail questionnaire.

Is your company currently using corporate bonds as a way of funding yourself?

If you do:

Since when are you issuing bonds?

What factor/factors lay behind the decision to start issuing bonds?

What are your main reasons for using bonds as a way of funding your company?

What type of bonds are you issuing, long term or short term?

In percentage, how much of your total loans consist of bonds?

Compared to bank loans, what are the main benefits with bonds for you?

Compared to bank loans, what are the main disadvantages with bonds for you?

Compared to bank loans, what is the rate of interest for your bonds?

Do you see a demand for local bonds from investors in the Baltics?

If not:

What other financial instruments are you using for funding your company?

What are the main reasons for using only those instruments compared to include bonds?

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35 Can you see any benefits with starting to issue bonds as an additional way of funding?

If you do, what is the reason that you choose not to use bonds?

If you wish to use bonds as a way of funding, is there any major factor holding you back?

(For example, uncertainties concerning the future or a lack of knowledge about how to do)

Is there any possible internal or external change that would make bonds a more attractive way of funding your company? (For example, higher interest rate on bank loans)

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36 8.4 Attachment 4: Questions for – and presentations of – Mr. Piho and Mr. Viikberg used in our video interviews

Private Debt Fund manager Mr. Peeter Piho

Mr. Piho managed fund in size of EUR ~100 mln dedicated to local (Baltic's) debt markets, unfortunately credit turmoil caused majority of fund investments to be restructured and by today fund is liquidated.

- 20/200 Mln. Euros are the lower limits for turnovers making a company interesting concerning bond issuing according to a Lithuanian expert, would you say that you agree?

- Biggest pros and cons with bonds? For Baltic/Estonian companies?

- Why do you think that bonds aren't commonly used today?

- What could change this?

- Were bonds more common previously? Before the financial crisis? Before the Swedish banks entered the market?

- Do the companies have the necessary knowledge? Do the companies know about the advantages of bonds or are they starring themselves blind at the interest rate?

-The benefit of diversifying the risk, has it got more attention after the financial crisis?

- Is it to tough to start issuing bonds for the smaller companies? Ratings, knowledge etc.

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37 - Are there any specific firm types that have an advantage in issuing bonds? E.g., do listed companies with public information have an advantage?

- What about ratings? Andreauskas claim that one big problem is that there are no credit ratings

available for the bigger part of the companies. Is this true? This must be a problem? In general we suspect that the ratings would be poor, how big of a problem is this?

CFO of Estonian Lottery Mr Charlie Viikberg

Mr Viikberg, started his career as equity broker in Swedbank, later moved to be deputy CFO of City of Tallinn, then deputy CFO of Estonian Railways and now CFO of Estonian Lottery.

- Biggest pros and cons with bonds? In the Baltics?

- When businesses decide how to finance themselves, are bonds mentioned in the board room?

- Do the companies have the necessary knowledge? Do the companies know about the advantages of bonds or are they starring themselves blind at the interest rate?

- Is it to tough to start issuing bonds for the smaller companies? Ratings, knowledge etc..

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38 - Do you see a demand for local bonds from investors in the Baltics?

- Is there any specific firm type that has an advantage in issuing bonds? E.g., do listed companies with public information have an advantage?

- What about ratings? Andreauskas said that one big problem is that there are no credit ratings