print 18.12.2006

REDIT-RATING: Distinctions in the Estimation of the Rating for Housing Bonds (Part I)

Topic  1: Housing Bonds as an Instrument of Cash Attraction for Residential Construction Financing

Among the different types of bonds i.e. interest, discount, housing, of the greatest interest are the latter. This has a rational explanation: these securities accord the right to obtain residential accommodation. In other words, having purchased zero-coupon (housing) bonds, it is possible to count on the fact, that after their original maturity expiration, it is possible to exchange them for a new apartment. The following paper shall be dedicated to the history of their use and examination of the regions where this method of financing residential construction is most widely used. 

For reference : Housing bonds, obligations under which shall be performed by goods and/or services according to the requirements, are set by the placement conditions of such bonds (the Law of Ukraine dated February 23, 2006, No.3480-IV regarding Securities and Stock Market). Most often zero-coupon bonds are used as an instrument of attracting funds for the financing of residential construction.

Housing bonds as an instrument of attracting funds for financing residential construction started being used several years ago., They became more widely used in 2006, when a number of amendments were introduced into current legislation, namely into the Law of Ukraine regarding Investment Activity. As a result, bonds replaced investment agreements, which had been used before.

At present housing bonds are popular with both the major customer the population, and the Issuers. Over the period from 2003 to December 1, 2006 the total amount of bonds, rated by our Agency exceeded UAH 19 billion. Of the total issued, those used for residential construction only, totaled UAH 11 billion, or 50 percent of the total amount (see Figure 1).

Figure 1. Share of Zero-Coupon Housing Bonds Issues Rated by Credit-Rating Agency during 2003- December 1 , 2006.

It is worth mentioning, that zero-coupon (housing) bonds have a number of peculiar features, which distinguish them from other kinds of securities and investment agreements. These bonds do not stipulate interest payment, but after the original maturity expiration, may be exchanged for real estate. Taking into account the fact that prices for real estate in Ukraine show a constant tendency towards increase, such investment funds seem to be quite advantageous and fully make up for the absence of an interest payment.

At the same time, as opposed to investment agreements, having purchased bonds, the customer obtains only the right to purchase residential space, which may be fulfilled after the original maturity of the bonds expires. It is worth taking into account, that as of the present date this form of issue contains one more mechanism hidden delay of payment. The majority of Issuers with the purpose of re-insurance specify in the issue prospectus, that calculations under the bonds may last for the period from half a year to two-three years after the original maturity expires. Therefore, the purchaser should pay attention not only to the time period of building the project, the term when the original maturity expires, but also to the final payment date.

There also exist a number of peculiar features, which are characteristic of these bonds only. In particular, it occurs very often , that the Issuer may be a company, which has no experience in construction work, which has been recently founded and the authorized capital stock is tens or even hundreds of times less than the amount of issue and does not exceed UAH 10 000 or UAH 20 000. Moreover, a number of such economic entities during the execution of the issue do not even have all the necessary construction permits as well as,do not have the property for the construction site, if a wasteland is located nearby, or, even the existence of a building, which is scheduled for demolition. It is quite clear that the terms of such residential construction shall not always constitute one or even two years, as can be stated by the investors.

There are also reverse situations, when shadow companies were established by large financial institutions or construction holdings, or, at least, the management board contains experienced experts, who have commissioned not even one project. The companies in this case are just nominal land-users, being the holders of the permits.

The peculiar features such as working experience, the issue and redemption of the bonds, timely commissioning of residential projects, including: the availability of permits (in particular, assignment of land plots for the construction and permission for conducting the construction work), entering the holding, which provides the necessary materials etc., are taken into account as well as the traditional indices of financial and economic activity, prospective of residential construction in the appropriate region, debt loading of the company etc. The result is the definition of the credit rating for the bonds, offered to the purchasers.

It is worth mentioning that the credit rating is not the acknowledgement, which is the guarantee of the Issuers unquestioning fulfillment of its responsibilities. This is the estimation of its reliability grade, a certain quality grade. Moreover, in estimating housing bonds, we try to predict the probability of timely payment with the purchasers, as delays in construction projects, even those that are almost totally completed are very widespread in Ukraine.

It is worth mentioning that at present, in the construction sector, the least share is the share of investment grade ratings. In percentage terms it is 8 percent of the total amount of housing bonds, issued for financing residential construction or 10 percent of the companies from the total number of Issuers (see Figure 2).

Figure 2. Share of Issues of Zero-Coupon Housing Bonds with Investment Grade Rated by Credit-Rating Agency as of December 1 , 2006.

From our point of view, the data, presented above, may be indicative of significant default risks as well as the risk of untimely non-performance by a great number of the Issuers for their obligations under the issued bonds. In fact this means the assignment of speculative ratings to more than 90 percent of the total amount of housing bonds.

In accordance with this the number of companies which have improved their rating history can be observed.  This is shown by following the construction schedules, timely commissioning of the residential space and redemption of bonds. Simultaneously, there is the tendency towards the complication of schemes of financing construction with the attraction of new financial instruments and institutions. In particular, moving from simple schemes with the use of bonds only, to payment by bills and bonds, the use of mortgage securities, creation of schemes of financing construction with the participation of institutions or joint investment and assets management companies. Therefore we consider that the residential market has prospect of further development, though, one should expect separation of influence spheres, and perhaps, a large number of defaults.

Thus, with the purpose for estimation of the reliability grade of the Issuer, and, accordingly, its capability to fulfill the obligations within the set term, one should demand from the Issuer information on the assigned credit rating. What is meant here is a certain estimation, made by the rating agency, and the final result of which is assigning of a certain letter abbreviation in accordance with the National Credit Rating Scale. The ratings with the letter denominations from С to ВВ belong to speculative grade, with denominations from ВВВ to ААА belong to investment grade. The more detailed information regarding the meaning of the correspondent grades for zero-coupon (housing) bonds shall be given in the following articles.

Grygoriy L. Pererva
Deputy Director General for Development and Research Issues
Director of Rating Research Department