When you apply for a loan to study abroad – with the hopes that you will make your spending worthwhile by landing a job there – you need to pay your EMIs on time and settle your loan, whether you obtain a job in your chosen destination, or not.
A completion bond subscribes to the same fundamentals.
Completion bond definition: what is a completion bond?
In a completion bond, investors lend money to bond-issuers for certain projects(most often construction and construction-related) and investors are paid back, with interest, at the predetermined maturity date, irrespective of whether the project was successful.
Benefits of investing in completion bonds
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Default risk is eliminated
Bonds are typically considered to be low risk stock market investments because a bond is a contract where the owner takes on the role of creditor and the bond issuer becomes the investor’s debtor. The bond issuer makes a commitment to return the investor’s capital by a certain maturity date and payout interest at predetermined intervals. This is why investors find bonds to be less risky than stocks – with their fluctuating prices. The risk associated with bonds is mainly linked to the bond-issuer defaulting on repaying the investors.
However, in completion bonds, this default risk is also eliminated because the bond issuer undertakes to pay back the investor irrespective of whether they manage to complete the project or not.
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Regular income
As with any bonds, investors can expect a regular income from regular interest payouts. In most cases, bonds pay out interest semiannually.
Depending on the amount that the bondholder has invested and the interest that the bond issuer has committed to, the investor could stand to earn a sizable amount. The bond issuer guarantees this interest payout.
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Portfolio diversification
For investors looking to diversify their stock market portfolio, bonds represent one of the important assets to consider. Completion bonds, by virtue of being low risk, can be a useful tool to offset risk in other investments.
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Liquidity
Investors are likely to find completion bonds desirable because of their commitment to repay investors irrespective of the project outcome, or completion. This means that they could fetch a good price on the stock market if the bondholder finds himself in a situation where he needs ready capital.
Considerations while investing in completion bonds
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Liquidity
It might seem strange that liquidity appears in both pros and cons. However, the stock market is very sensitive to news and often reacts illogically to the news.
For example, let’s say Minal owns a completion bond of construction company X and that the bond price had been hovering around Rs 5,000. Suddenly, there is news of increased taxation on construction projects; the price of company X bonds drop by 30% overnight. Nobody seems to remember that the investors have received a commitment that they will be repaid irrespective of whether the project is completed – and what does increased taxation have to do with it anyway? But this is a typical knee-jerk reaction that smart investors learn to ride out. Better sense prevails… eventually.
Minal would ideally wait until better sense prevails and the bond prices climb back up again. But that makes the bond illiquid as long as the prices are not optimal.
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Volatility exposure
It is a common misconception that bonds come with no volatility exposure because as you might have noted in the example above, they do indeed come with volatility exposure, should the investor want to regain his capital prior to the predetermined maturity date.
Any investor looking to trade bonds on the stock market must have at least a basic handle on how the stock market moves and functions; how to make predictions and use technical analysis and so on.
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Rate of interest
Completion bonds might often be very long term and the returns being earned might become very nominal or negligible as time goes by, especially if the rate of interest is very low. Avoid getting swayed by the guarantee of repayment and pay attention to the interest rate that you will be receiving, the intervals at which the interest will be paid out, and whether it will be guaranteed, fixed or floating interest.
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Costs
Completion bonds may come at a high cost to the investor because there are typically three parties involved – the bond issuer, the bondholder and the guarantor. The guarantor is usually a third party (it could be a financial institution, a risk management firm or an insurer) who evaluates the risk in a given project and provides insurance cover that will be paid out in case of non-completion. As you know, insurers charge hefty premiums and of course, that cost is passed on to the investor eventually.
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No hiding from risk
What if there is some situation that plays out and the insurer manages to worm out of paying up when the project falls apart? The bond issuer might haul the insurer to court, but it might take years – even decades – while the two battle it out in court, and in the end the investor’s capital is still either stuck or even lost, depending on how the case plays out.
Conclusion:
Completion bonds can be an ideal low risk investment avenue, but risks are a given in any stock market investments and therefore invested should consider their risk appetite and the risk-reward ratio of a specific completion bond before investing.
