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Perpetual bonds: Good or bad? (Read comments too.)

Tuesday, March 13, 2012

With interest rates so low these days, one would not be wrong to wonder why are companies and even a REIT issuing perpetual bonds to raise funds with coupons of up to 7%. To a layman like me with very rudimentary understanding of economics, it could be one of two reasons:

1. The business or REIT concerned is not able to get loans because its business is too risky.

2. The amount of liquidity available in the banking system is drying up.

I do not have the necessary knowledge to do an in depth analysis on the reasons why. Indeed, I do not have the inclination as well. I am more interested in how these bonds might benefit me as an investor.

Generally, investors want to be correctly compensated for the risks they are asked to undertake. So, the riskier the investment, the higher the expected compensation. Otherwise, it is a no go.

However, with imperfect knowledge, investors sometimes get the shorter end of the stick. There are examples aplenty of investments gone sour. With the benefit of hindsight, investors learn to avoid similar experience in future or we hope to anyway.

When something new comes along, relying on past experience becomes impossible. Indeed, investors are sometimes misled through creative labelling. Remember the "mini bonds"? The resulting losses were in no way mini.

Now we have "perpetual bonds". What are these?


Perpetual bonds are bonds with no maturity date and investors are not allowed redemption. A glaring disadvantage of such an instrument is the lack of liquidity. Therefore, people with very deep pockets who would never be in an urgent need of cash are more suitable investors.

No matter the depth of one's pockets, however, there is a universal problem of inflation. With inflation in Singapore at more than 5%, if one should park one's money in a perpetual bond that yields 5% or less, it does not make much sense. Add this to the lack of liquidity of such an instrument, more or less, it amounts to an almost complete loss of control over one's dwindling wealth. Ouch.

Perpetual bonds are a no go for me. However, if the companies and REITs I am vested in should issue perpetual bonds to fund activities which would grow EPS or DPU, I would raise both hands in support.

Like anything in life, whether something is good or bad depends on where one stands.


UPDATES:

The absence of a maturity date means perpetuals usually offer higher yields than bonds with one. Companies are taking advantage of Singapore accounting rules that count the notes as equity and a tax law that exempts interest payments.

The lack of a perpetual's maturity date, in spite of the incentive to redeem at the first call, allows issuers to treat that debt as equity in their books. That reduces the companies' leverage even as interest payments increase.


"The impact on the market is hard to judge" if any issuers choose not to repay, said Dilip Parameswaran, the Hong Kong-based head of Asia Investment Advisors Ltd. "The Singapore dollar market is small and dominated by domestic institutional and retail investors. They may have invested based on an expectation of call, and may be disappointed if the bonds are not called."

As companies consider the cost of refinancing, he said, "if the secondary yields are higher than the step-up coupon, then it makes no sense for the company to call the perpetual."

Source: http://www.businesstimes.com.sg/banking-finance/singapore-perpetual-bond-investors-hope-never-means-three-years



AK says:

What we want to be wary of is also what rising interest rates would do to bond prices. As interest rates rise, bond prices fall. That is the relationship.

For bonds with maturity dates, we just have to hold to maturity and hope that the issuer does not default. We would get back our capital at maturity. With perpetual bonds, there is no maturity date.


Related posts:
1.  Dr Marc Faber: How not to lose money?
2.  To protect our wealth, we have to take risk.

22 comments:

Data said...

I broadly agree with you on the desirability of perpetuals from an investor's point of view, but in the case of REITs issuing perpetuals, I think there is more than meets the eye. I got some of these ideas from this brief analyst report from UOBKH on Mapletree Logistic Trust's recent $350m issue of 5.375% perpetual securities: Property Nuggets: A closer look at perpetuals.

From the point of view of most companies, 5% perpetuals are expensive capital compared to 2% from banks or up to 4-5% from shareholders, in terms of the dividends that are paid out for common stock. But from the point of view of most REITs, perpetuals can be an attractive source of capital because their distribution yields are so high.

For example, MLT's distribution yield is now 7+%. Shortly after completing the perpetuals issue it announced some acquisitions in Japan and said that the properties will give a stable NPI yield of about 6.2% (announcement). The acquisition is yield-accretive when financed by perps but not if financed by rights issues or private placements. Debt could be even cheaper but MLT may be reluctant to go beyond 40% gearing.

In short, will REIT managers increasingly raise money for acquisitions or other purposes by selling perps at $250,000 each to sophisticated investors rather than from unitholders? What will be the effect on unitholders' rights and returns? Considering perps rank higher than stock and are cheaper sources of capital.

What do you think?

Going Merry said...

Hi AK

Good post, thanks, clarifies some of my own thoughts :)

Regards
Going Merry

AK71 said...

Hi Data,

In MLT's case, the perpetual bond's coupon of 5.375% is still cheaper than issuing rights since its distribution yield is 7+%. And since it is able to put the funds to good use by purchasing properties which give a higher rate of returns than the coupon it pays on these bonds, it is going to increase DPU for unitholders. Good news for unitholders!

However, unit holders would have to accept that in the event of a default, these bond holders would have priority over them in terms of rights and claims to the REIT's assets.

So, perpetual bonds could result in higher returns for unit holders while weakening unit holders rights and claims. Sounds fair to me.

AK71 said...

Hi Going Merry,

You are welcome. The blog post is an attempt to sort out my own thoughts. If it has helped anyone reading it, I am glad. :)

S-REIT Investor said...

Hi AK,

Are perpetual bonds considered debts in the balance sheet, and will thus raise the gearing in the case of Reits? Any idea?

AK71 said...

Hi S-REIT Investor,

A reason why many are expecting other S-REITs to hop on the bandwagon and issue perpetual bonds is because they are treated as part of the equity structure. So, gearing would actually drop and in the case of MLT, gearing dropped from 42% to 38%, post bond issue.

Ray said...

great article.
i was wondering why companies are issuing PB when interest rate is so low.

AK71 said...

Hi Ray,

Thanks. I was really just thinking aloud here. ;)

Serendib said...

Regardless of what MAS says, perps are simply junior/mezz debt. And additional debt is an issue for equity. Sure it turbocharges equity returns, but not only is more cash-flow dedicated to debt service, equity holders are also pushed further down in terms of security.
When the tide goes out we'll see who's not wearing their swimmers - with apologies to WB

AK71 said...

Hi Serendib,

Indeed, they are a form of mezzanine financing. As with all forms of financing, if there is productive use for the funds, it is a plus.

Of course, the fear is always in over leveraging. People tend to become complacent during boom times.

Serendib said...

Hi AK,

yes - debt is all well and good for the REITs when times are good and cashflow is strong. But in a downturn the debt still needs to be paid (although for perps its only interest and there's no refi risk). I wonder if anyone has done a calc of the DSCR (debt service cover ratio) on these REIT's c/f...

AK71 said...

Hi Serendib,

I know a fear with REITs using perpetual bonds is whether the NPI yield might fall in future. In the case of MLT, if its NPI yield should fall to 5.375% or lower, then, it might make sense to redeem the perpetual bonds then.

I believe REITs usually include interest cover ratio in their quarterly reports. Most S-REITs' loans are not amortising in nature. So, I doubt they calculate debt service coverage ratios which would include principal repayment.

Vatsa said...

You can stick lipstick on a pig, but it still remains a pig.

Broadly, this is just dilution of existing REIT shareholders.

As far as the issue of other companies go, it is basically a case of mispricing.

A savvy lender will not lend it so cheaply, he / she will ask for the appropriate risk premium.

A not so savvy lender aka individual investor will lend it at this interest.

The lenders will be the losers in this case.

They bear a higher risk for a lower return.

AK71 said...

Hi Vatsa,

Perpetual bonds issued by REITs would actually increase DPU for existing unit holders if the funds are used to purchase assets which would generate higher returns than the coupons payable although in the unlikely event of a default, unit holders would rank lower than perpetual bond holders in their claims. Win some, lose some.

As for whether a lender is savvy or not accepting coupons of up to 7% on perpetual bonds, that is more subjective. Personally, I would not touch perpetual bonds for reasons listed in this blog post.

Data said...

Earlier I commented on why REITs would find perpetuals especially attractive. Here is why they will find them irresistable: a regulatory loophole.

If MAS treats perpetuals as equity, that means they do not count as debt and are not included in the gearing caps of 35% or 60%. Indeed, as ASSI notes, the more perpetuals issued, the lower the gearing gets.

At the same time, the ability of managers to create new units or issue instruments that create new units, like rights, warrants and convertibles, is limited in shareholder resolutions voted on every year. For MLT the caps are 50% of the issued units, 20% if the new units are not issued pro rata. I think these rules and percentages are quite standard. But perpetuals are also not new units and do not create new units!

So in theory REITs can release as many perpetuals as the market will bear and in this way jack up their leverage quietly. Once the next credit crunch or property downturn comes, both perpetuals investors and unitholders are going to get burnt.

AK71 said...

Hi Data,

Perpetual bonds do not have a redemption date. So, the issuer could simply continue to pay the coupon. There is no need to seek refinancing. So, in the event of a credit crunch, there should not be an issue.

However, I agree that in the event of a property downturn, things could turn ugly and this is a more probable scenario. Indeed, I mentioned earlier if the NPI yield of a REIT's portfolio should fall below the coupon of the perpetual bonds it issued, it might have to redeem the bonds.

As an aside, I see larger REITs with stronger sponsors as the ones who are more likely to issue perpetual bonds. Smaller REITs might have to pay a very expensive coupon to do the same which might make perpetual bonds unpalatable to them.

hydrogenperoxide said...

I do think that the most underlying reason to issue this perps is the "no need to refinance" and ability to lock in the low interest perpetually for now. with interest rate so low now, they are afraid to miss the opportunity (for REITs with large sponsor)

AK71 said...

Hi pero,

For sure, this is an attractive option for companies and REITs as perpetual bonds are treated as equity and not debt.

The jury is still out on whether perpetual bonds are here to stay but going by how they have been lapped up by investors, their future does look promising.

Cory said...

To redeem PS, Reits will have to raise cheaper money to do that. In bad times, how easy is that other than issuing Rights ?

AK71 said...

Hi Cory,

If NPI yield should fall to a level which is lower than the coupon rates of the perpetual bonds, it would make sense to make a redemption. At that point in time, we could see equity fund raising and it could either be a rights issue or a private placement. We shall have to cross the bridge if we come to it.

AK71 said...

A-REIT said on Monday it would issue S$300 million worth of subordinated perpetual securities that pay a distribution at the rate of 4.75 per cent.

The manager intends to use the net proceeds to partially fund the acquisition of a portfolio of logistics properties in Australia.

A-Reit has been assigned an "A3" issuer rating and the securities are expected to be rated Baa2 by Moody's Investors Service, Inc.


Source:
http://www.businesstimes.com.sg/companies-markets/a-reit-to-issue-s300m-perpetual-bonds-at-475

AK71 said...

The OTC bond market in Singapore is an example of a generally illiquid market. It’s reserved for accredited investors with private banking accounts due to the minimum lot size of the bonds traded – usually S$100,000 or S$250,000 a pop.

As there’s no visible exchange, prices quoted are simply based on a handful of sellers and buyers via their intermediaries, therefore the huge bid/ask spread in the bonds. Oil and gas companies with OTC bonds have seen their bond prices plummet, some trading at 80 cents on the dollar. If you’ve bought that bond on margin, it could’ve triggered a margin call. If you can’t shore up additional collateral, the bank will do a force-sale which would inevitably sell your bond at a very low price due to illiquidity.

Risk management would be key here as with all investments, but liquidity risk would be of the greatest importance in this market due its non-transparent nature.


Source:
http://fifthperson.com/a-simple-guide-to-how-market-liquidity-affects-your-investments/

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