Breaking Down Perpetual Bonds (& Perpetual Securities)

[juno.tay]

There's been considerable interest in the offering of a perpetual security issues among a host of different companies in Singapore of late.

Before going into the bond offerings themselves, I want to point out that whether it be a common share or bonds, the investor still needs to do their proper due diligence and find out if the company has the ability to fund its liabilities.

The fact that the issues are "bonds" do not necessarily confer safety to it, as large companies such as Enron, Worldcom and Lehman Brothers among others have defaulted on their debt before.

To make this less alien to less acquainted with fundamental analysis, let us pretend that for a moment that a fictional person, John, has come to us to borrow money.

John runs a rather successful business that's generating a reasonable amount of money, and he wants to borrow $500 million from you.

He tells you that last year, he roughly generated about $1 billion of cash inflows from operating activities. However, he spent about the same amount in capital expenditures (property, equipments etc) which was not reflected in the net profit figure. So effectively, last year, he generated close to nothing in "free cash flow".

However, he now tells you that his business has a net worth (assets - liabilities) of about $2.7 billion. However, upon examination of his balance sheet last year, you realise that he already has

1) Short term borrowings - $450 million
2) Long term borrowings - $2.7 billion

And then you soon find out that about a month back, he already borrowed $1.8 billion from someone else.

So assuming that you lend him the extra $500 million he wants, his total debt levels will be:

1) Short term debt - $450 million
2) Long term borrowings - $5 billion

Total - $5.5 billion. Assuming that they are borrowing at around 5% per annum, that's 275 million in interest paid per annum, or about 27.5% of what he made last year.

Let's ignore all this for a moment, and listen to his conditions.
In exchange for you lending him the money, he's willing to pay you an interest of 5.125% , considerably more than what the bank is paying you. However, one must wonder, why is he offering an interest rate higher than what other people are offering you?

Let's also pretend to ignore this nagging fact, and look at the terms in greater detail:

He tells you that:

1) These are PERPETUAL securities that have no fixed redemption date
2) He reserves the right to pay your money back after 5 years if he so elects to

In other words, he's telling you that you are only going to see your capital back if he so elects to.

Now, let's just speculate for a moment, why on earth would he want to pay you back after 5 years? The following (but not all encompassing) springs to my mind:

1) He suddenly decides that he's overloaded with debt and he should actually pay the money he owes back first
or my personal favourite
2) Interest rates head even lower than they currently are, allowing him to borrow the same amount of money at a even lower cost.

Rationally, why on earth (assuming he needed the money still), would he pay you back, only to borrow the equivalent sum at a higher interest rates 5 years later? And with interest rates as they are now, what's the more likely scenario, interest rates going up, or down?

Finally, let us return to the subject of why he would need to even borrow so much money, considering he runs a decent business generating considerable profits.

You sound find out that he's looking for opportunities elsewhere in Asia, and the money he borrows is going to expand his business. In other words, you are essentially paying for his future growth.
Now, if you have a significant knowledge about his business, and the risks he takes going forward, and even perhaps what his company is going to be like 5 years from now, than I will say fair enough. This is certainly not my area of expertise, all I can caution is that I certainly hope it's yours before you consider lending him money.

At the end of the day, I hope that investors should consider the following before deciding for him or herself whether he or she would lend money to such an individual.

Cheers.

[Musicwhiz]

There's been considerable interest in the offering of a perpetual bond issues among a host of different companies in Singapore of late.

Hi, thanks for your (long) explanation. But I'd just like to remind that the companies in Singapore had been issuing perpetual securities, and not bonds. Therefore, they would be classified as equity and not debt; though the payments are also contractual and cumulative. They can be deferred but cannot be dismissed.

Please see a forum letter in today's ST mentioning this (by Mr. Mano).

The Straits Times
Apr 16, 2012
Perpetual securities not the same as perpetual bonds

THERE are major differences between perpetual capital securities and perpetual bonds, and these terms should not be used interchangeably ('Genting S'pore reaches out to retail investors', last Tuesday; and 'Genting may be a sure bet but know risks of perpetual bonds', last Wednesday).

A bond is an IOU, and is listed as a liability on the balance sheet of an issuer, whereas perpetual capital securities are accounted as capital of the issuer.

Also, a bond receives regular coupon payments; perpetual capital securities receive dividends/distributions (at the discretion of the issuer). A missed coupon payment on a bond can result in a credit event or default. In contrast, perpetual securities can afford to miss dividends/distributions without any credit event.

A bond is ranked above a preference share and, in some cases, has the same ranking as creditors; perpetual capital securities may rank lower than creditors, or in line with preference shares.

It should also be noted that bonds, preference shares and perpetual capital securities are all plain vanilla or straight instruments and have been in existence for a long time.

In the case of the various perpetuals that have been issued in the Singapore market in the first quarter of this year, for example, those by Genting and Ascendas, they are not convertible; giving the impression that these products are hybrids is inappropriate.

A hybrid refers to a product that has equity and bond features, for example, convertible preference shares or convertible bonds. Thus only those securities that have both the characteristics of bonds and equity would qualify as hybrid securities.

I am unaware of any current perpetual bond issue in the Singapore market, though they may exist elsewhere.

Mano Sabnani

[juno.tay]

Thanks for pointing this out, I am afraid I have used the term interchangeably. Have corrected it as above.

Cheers!

There's been considerable interest in the offering of a perpetual bond issues among a host of different companies in Singapore of late.

Hi, thanks for your (long) explanation. But I'd just like to remind that the companies in Singapore had been issuing perpetual securities, and not bonds. Therefore, they would be classified as equity and not debt; though the payments are also contractual and cumulative. They can be deferred but cannot be dismissed.

Please see a forum letter in today's ST mentioning this (by Mr. Mano).

The Straits Times
Apr 16, 2012
Perpetual securities not the same as perpetual bonds

THERE are major differences between perpetual capital securities and perpetual bonds, and these terms should not be used interchangeably ('Genting S'pore reaches out to retail investors', last Tuesday; and 'Genting may be a sure bet but know risks of perpetual bonds', last Wednesday).

A bond is an IOU, and is listed as a liability on the balance sheet of an issuer, whereas perpetual capital securities are accounted as capital of the issuer.

Also, a bond receives regular coupon payments; perpetual capital securities receive dividends/distributions (at the discretion of the issuer). A missed coupon payment on a bond can result in a credit event or default. In contrast, perpetual securities can afford to miss dividends/distributions without any credit event.

A bond is ranked above a preference share and, in some cases, has the same ranking as creditors; perpetual capital securities may rank lower than creditors, or in line with preference shares.

It should also be noted that bonds, preference shares and perpetual capital securities are all plain vanilla or straight instruments and have been in existence for a long time.

In the case of the various perpetuals that have been issued in the Singapore market in the first quarter of this year, for example, those by Genting and Ascendas, they are not convertible; giving the impression that these products are hybrids is inappropriate.

A hybrid refers to a product that has equity and bond features, for example, convertible preference shares or convertible bonds. Thus only those securities that have both the characteristics of bonds and equity would qualify as hybrid securities.

I am unaware of any current perpetual bond issue in the Singapore market, though they may exist elsewhere.

Mano Sabnani

[Musicwhiz]

Words of caution from Goh Eng Yeow.

The Straits Times
Apr 23, 2012
CAI JIN
Perpetual bonds carry risks, so do your checks
They offer attractive returns but there are potential pitfalls too

By Goh Eng Yeow

RETAIL investors finally got a chance recently to jump into the latest investing fad here, perpetual securities - and they seized it with both hands.

But as local interest grows in this seldom-seen type of security, similar to preference shares, investors should consider some of their potential pitfalls, as well as the attractive returns.

Casino giant Genting Singapore directed its issue squarely at small-time investors who were attracted by the hefty 5.125 per cent interest payment, known as a coupon rate, offered by the shares.

Genting was tapping into pent-up demand as retail investors had been left out in the cold in recent perpetual securities issues, directed only at the big boys.

The outcome: Genting raised $500 million from 21,594 retail investors.

This was on top of the $1.8 billion it netted from an earlier perpetual securities issue last month.

Perpetual securities are nothing new. They are bond-like instruments which offer their holders a fixed payout, but no voting rights.

But unlike bonds, in which both the principal and interest must be paid to investors according to a fixed schedule, perpetuals allow an issuer to defer coupon payout under certain circumstances. The repayment of the principal is also left at the issuer's discretion.

For issuers, one big attraction of perpetuals is that they can be structured to count as equity, rather than debt, on their books.

The other big plus is that an issuer can raise capital without diluting its equity base. Given the uncertain market conditions, this relieves the pressure on its share price that would otherwise have been triggered by a cash call such as a rights issue or a private share placement.

Until last year, only the bluest of the blue chips such as DBS Group Holdings, United Overseas Bank and OCBC Bank have been successful in attracting investors to buy perpetual securities which they labelled as preference shares.

Things however changed last year when water specialist Hyflux netted $400 million - double the sum it was hoping to raise initially - from a perpetual securities issue.

The enthusiasm didn't end there. Investors were struck by the brisk buying interest in the Hyflux perpetuals after they were listed.

Even though the mother share has suffered a 25 per cent drop since August last year, amid market turmoil, the perpetuals are trading at a 6.2 per cent premium to its $100 issue price.

It is not surprising that with the Hyflux experience in mind, investors have been loading up on the Genting perpetuals. Since its debut last Thursday, the security has attracted a total volume of 18.6 million shares in two days of trading, closing with a 1.9 per cent premium to the $1 issue price at $1.019 on Friday.

This prompted Mr Clifford Lee, the head of fixed income at DBS Bank, which has managed the lion's share of the perpetuals launched this year, to suggest that other issuers might well follow in Genting's footsteps in tapping on the broader retail investor base.

'We will hopefully see more retail bond offerings in the near future. With the strong first-day performance of the Genting perp in the retail market, this will certainly spur more interest from potential issuers and hasten more discussions for similar offerings,' he told The Straits Times.

Still, despite the exuberance, a word of caution is needed, as such instruments appear to have lured many risk-averse investors who have not touched the stock market in years.

Some sceptics believe that there must be a catch somewhere. To them, the fact that an issuer is prepared to offer such an attractive coupon payout is simply too good to be true.

As one blogger observed: 'In exchange for you lending him the money, he is willing to pay you interest of 5.125 per cent, which is considerably more than what the bank is paying you. One must wonder why he is offering an interest rate which is much higher than what other people are offering you.'

But some have noted that the higher 'interest rate' is to compensate buyers for leaving repayment of the principal at the issuer's discretion.

Outside of Asia, interest in perpetuals is almost non-existent. Europe has seen no deals this year, while North America has seen just four deals worth US$986 million (S$1.24 billion), according to Dealogic.

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 bust and failed to make their usual coupon payout.

That should serve as a cautionary tale. Retail investors should do a few checks before placing money in perpetuals.

First and foremost, it is important to evaluate the business model of the issuer and stress-test its cash flow to make sure that it has the ability to make the coupon payout. There is no point in getting lured into a perpetual which offers a big coupon rate only to find out that the company is unable to make the payment.

Since the issuer of the perpetual is under no compulsion to redeem the principal by a certain date, the only way an investor is able to get his capital back is by selling the perpetual in the market. So it is vital to consider the liquidity of the perpetuals before buying them.

So far, retail investors have not experienced any problem selling perpetuals traded on the Singapore Exchange, but well-heeled investors who bought into institutional offerings have complained of a big difference between the buying and selling price quoted to them.

One encouraging sign, however, is that most of the perpetuals issued so far this year by companies such as Global Logistic Properties, Singapore Post and Olam International are trading well above their respective issue prices.

The fact that an issuer of perpetuals can forgo a dividend payout without triggering default also places a big emphasis on the features to protect investors if such an event occurs.

Most of the perpetuals this year comes with a 'dividend stopper'. This means that the issuer will not be able to pay any dividend to its shareholders unless it makes good on all the deferred coupon payments.

That makes it important for an investor to check a perpetual issuer's dividend payout record.

Singapore Post was able to issue a 4.25 per cent coupon because the company enjoyed a steady dividend track record since it was listed almost 10 years ago. In contrast, Genting offered a higher 5.125 per cent payout, as it only started paying out dividends since last year.

engyeow@sph.com.sg

[Thriftville]

Great info! Thanks MW!

[safetyfirst]

hi i was reading up on perpetual securities, after much research, it seems like perpetual securities is the same as preference shares, am i wrong to say that?

[specuvestor]

Any security without a maturity date is considered perpetual. So yes most type of equities are one type of perpetual security, with some having options embedded.

From cashflow perspective pref shares and perpetual bonds may look the same but they are different in terms of credit and the former usually has a cumulative function.

"Smart" corporate finance people thought of issuing perpetual bonds because they realised this means you don't have to worry about refinancing or repaying the principle. How does that sound to you?