Perp Talk

Foreword from ShareInvestor

This article “Perp Talk” by Lorna Tan was first published in The Straits Times on 24 Jun 2018 and is reproduced in this blog in its entirety.

Perpetual securities should not be confused with conventional bonds and should be considered with caution

The recent trading suspension of perpetual securities (perps) issued by water treatment specialist Hyflux has left investors out on a limb – and out of pocket.

Prior to the suspension, Hyflux’s failure to pay last month’s coupon of its $500 million 6 per cent perps had resulted in an event of default.

Perps are securities that do not have a maturity date but they usually have what is known as a call date, which is when the issuer can redeem or buy them back from investors.

While the issuing firm is under no obligation to redeem the perps on that date, traditionally they have done so – until now.

There are two Hyflux perp issues – one issued in April 2011 with the first call date in April this year, while the one issued in May 2016 has its first call date in May 2020.

Financial experts say that when issuers do not redeem on the first call, it is a message that they are having liquidity problems, which is precisely what is happening at Hyflux.

While the collapse in prices and suspension of Hyflux perps may have caused some anxiety, the issues are specific to this firm and should not tarnish the reputation of perpetuals.

Due diligence and understanding what you are investing in are key.

Ms Teh Hooi Ling, portfolio manager of Inclusif Value Fund, says that like for all investments, investors should always try to ensure that the rewards are commensurate with the risks being taken.

“In this low-yield environment, investors may get seduced into securities with yields that are optically high. However, the accompanying risks could be disproportionately higher as well,” she adds.

“Also, each investment security has its own nuances, meaning that two perpetual securities could have very different terms and conditions, which affect the risks borne by the holders.

“Investors should examine the structure of the security (such as call provisions, step-up provisions, deferred interest payments, and so on) before making the decision to invest.”

Ms Teh says the impact on Hyflux perps holders will depend on how the firm’s financial reorganisation pans out.

The Sunday Times highlights what you need to know about perps.

What Are Perpetual Securities?

Perps share some of the features of both bonds and shares. Although they are often referred to as “perpetual bonds” or “perpetual notes”, they are not to be confused with conventional bonds and should be considered with caution, says national financial education programme MoneySense.

Issuers of perps usually offer to pay fixed distributions or coupon payments. However, unlike bonds, perp issuers often have the discretion to stop paying distributions altogether without triggering a default. Perps have no maturity date, so they can continue in perpetuity unless redeemed by the issuer.

Features Of Perpetual Securities

Most perps pay a distribution, such as a fixed interest rate at fixed intervals, typically every six months.

Deferral Of Distribution Payments
While perps pay out, there are clauses that allow the issuer to defer or halt payments (depending on whether the perps are cumulative or non-cumulative) under certain conditions without having to seek investor consent.

This would constitute a default in many investment products but not for a perp issuer. And the non-payment period could continue indefinitely, so investors would be left high and dry.

Given the possibility of a distribution deferral, investors should not depend on perps as a source of regular income, say financial experts.

A decision by the issuer to defer distributions or to not exercise its redemption right at a scheduled call date might well be viewed negatively by investors, and that in turn could affect the prices of perps on the secondary market.

Noble Group Holdings is one perp issuer that has deferred its distribution payments recently.

No Maturity
Perps have no maturity date, so the issuer has the right to never return the principal amount to you.

A Call Schedule
While perps have no maturity date, the issuer may have the right, but not the obligation, to call or redeem the securities on specified dates according to a call schedule. For example, call dates can occur from the third, fifth or 10th year after the issue date.

Firms that issue perps are more likely to redeem them if they can borrow at more favourable rates.

If interest rates have fallen since the securities were issued, or if the firm’s credit standing has improved, it might make sense to redeem the perps.

Note that you may not be able to reinvest at a similar interest rate if the perp issuer hands your cash back.

If the issuer exercises the call, it can pay you the principal amount in full or in part. If the call is not exercised or if there is no call schedule, the perps could exist forever without being redeemed. This means you would never get your principal amount back.

Step-Up Feature
This refers to a condition that obliges the issuer to pay a higher rate of interest after a certain number of years if the perps have not already been redeemed.

MoneySense advises that you should not take the presence of a step-up feature as an indication that the issuer is likely to exercise the right to redeem the securities before the step-up interest rate kicks in.

If the issuing firm’s financial standing has worsened and its borrowing costs have risen, it may find it cheaper to pay the step-up interest rate and decide not to redeem the perps.

For instance, Hyflux perps issued in 2011 came with a step-up interest rate of 8 per cent a year if it missed the call date, which was in April this year.

No Voting Rights
Perps do not entitle their holders to voting rights, unlike shareholders, who can vote on important corporate matters such as a major acquisition or the divestment of assets.

Financial Covenants
Some perps contain little or no financial covenants, so you will have little recourse when the issuer experiences financial problems. This is unlike most bond issuances, which usually provide covenants as safeguards for investors.

The absence of financial covenants means the issuer has more flexibility in running its business, but that can also mean it is under no obligation to operate in a financially prudent manner.

It could, for example, pursue short-term growth by taking on debt beyond a level that is sustainable.