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Risks associating with Perpetual Bond

Some called it Perpetual Bond, some called it ‘Hybrid Bonds’ and some named it ‘preference shares’…is hot in Singapore!  In just four month this year, companies have raised S$12 billion or 57% of the S$21 billion raised on the bond market last year.  They are hot because interest rate is low and cash rich people don’t know where to park their monies and as such, they find such investment instrument attractive!  But do watch out!

First, facts from Dealogic: Asia appears to be only place to lure such a huge interest; in Europe, no deals is seen this year;  in North America, it has seen only four deals worth US$986 million.  Reason?  “Interest in such instruments in these two markets abated considerably when the perpetuals issued by well-known companies such as US mortgage giants Freddie Mac and Fannie Mae were written off completely during the 2008 global financial crisis, after they went burst and failed to make their usual coupon payout.”

Next, what exactly is perpetual bond? In a layman term, it is a ‘long-term bond’ which has no expiry date but can be ‘called’ to terminate when needed.  Why companies are launching perpetual bond?  The key reason is companies are just taking advantage of the low interest rate environment to raise capital.  The advantage of perpetual bond to the issuer (company offering the perpetual bond) is it can been ‘seen’ as equity rather than debt, thus ‘beautifying’ its balance sheet which would in turn maintain its credit ratings while doing acquisitions.  To put it another way, they ‘look’ like incredibly ‘cheap equity’.

But there are risks associated with such investment and they are:

  1. No matter how it is being named, the reality is they are still ‘debt’ or bond which may subject to hiking interest rate risk – as interest rate hike, bond price will fall.  Bill Gross of PIMCO Total Return fund manager last year was concerned of US interest rate hike.  What action he took?  He sold all its US T-bill holdings.  Why?  Because if the Fed were to start hiking the interest rate, T-bill performance would be nasty as the bond price would fall!  The implication of the interest rate risk is even more significant for long term bond not to mention for bond of no maturity date!  For completeness, year 2011 was Bond King’s – Bill Gross worst run since at least 1995.
  2. The perpetual bond has ‘call’ date, which leaves the repayment at the issuer’s discretion.  During the financial crisis, investors learned that many banks then declined to call, or redeem the bond because they needed the capital!  In such situation, the only way an investor is able to get his capital is by selling the perpetual bond in the market.  In times of panic, there could be no buyer! Reckless person
  3. In the event of liquidation or bankruptcy, the recovery for perpetual bondholders could be minimal as they are ranked just above common equity holders.  This is precisely what happened to Freddie Mac and Fannie Mae – investors have to write off completely!

The history of perpetual bond is short in Asia.  It took off only in 2010 and 2011.  In such a low interest rate environment, having no prior (first hand) experience in such instrument together with the ‘feeling’ of ‘guaranteed yield rate’, perpetual bond is only ‘attractive’ prior to the interest rate hike.  Remember large crowds and small doors are no fun.  Even Bond Kind – Bill Gross was so fearful that he had his worst run as he was too early rushing for that exit in anticipation of the Fed hiking the interest rate last year!

Reference:

  1. Bloomberg, 20111104, “Bill Gross Rebounds from bottom ranking as risker assets surge”
  2. Financial Times, 20120307, “Asian Hybrid Bond Issuance Soars”
  3. BT Invest, 20120319, “Beware risks of corporate perpetual bonds’
  4. Straits Times, 20120423, “Perpetual Bonds carry risks, so do your checks”
  5. Straits Times, 20120424, “Huge demand for corporate bonds this year”