Ups And Downs When Investing In Perpetual Securities

Foreword from ShareInvestor

This article “Ups And Downs When Investing In Perpetual Securities” by Lorna Tan was first published in The Sunday Times on 24 Jun 2018 and is reproduced in this blog in its entirety.

While they offer higher coupons, they come with interest-rate and credit risks

Perpetual securities (perps) have been making headlines lately and likely giving investors second thoughts about adding them to their portfolios. The source of the most recent concerns stems from water treatment firm Hyflux’s decision to suspend trading in its perps.

But while perps have downsides, including no maturity date, they can work for some investors.

Ms Cheng Xin Yi, DBS Private Bank’s fixed income analyst, notes that there are several advantages when it comes to perps.

One is that investors get predictable interest payouts, and usually bigger payouts as the coupon rate is often higher than straight/plain vanilla bonds to compensate for their lack of maturity dates and issuers’ ability to defer coupons.

If the firm goes into liquidation, perps are ranked higher than ordinary shares and on a par with preference shares in the capital structure, so you may emerge with some cash.

“Investors may also want to look out for perps with features such as coupon reset/step-up feature, which helps to mitigate interest rate risk in the event the issuer decides not to redeem the perp at the call date,” says Ms Cheng.

Here are some of the pros and cons of investing in perps.

Pros

More Stable And Regular Income Flows

Relative to equities, perps are generally more stable and produce a more regular cash flow, notes Ms Teh Hooi Ling, portfolio manager of Inclusif Value Fund.

Like plain vanilla bonds, the coupon payments or distributions occur on a fixed schedule. Although in most instances, the issuer can defer payment without triggering a default, the likelihood of that happening is lower than a company skipping its dividend payment to shareholders, adds Mr Ang Chung Yuh, senior fixed income analyst at iFast Corporation.

Higher Coupons

Perps generally offer higher coupon payments than bonds.

Mr Ang says investors who take the effort to do due diligence and sieve through the technicalities may be able to identify perps that offer decent yields with a low default risk.

Bear in mind that holders of perps would have to contend with the uncertainty in tenure and often a ranking lower down in the pecking order in the capital structure.

Redemption

Usually perps have a provision that allows issuers to call them back after, say, five years.

It is almost industry practice for issuers to do this, so investors would be getting a higher interest rate for essentially investing for five years rather than for perpetuity, says Ms Teh.

If the perps are not called back on the designated date, there will usually be a condition that forces the issuer to pay a higher interest rate. This is known as a step-up feature.

Mr Ang notes: “This penalises the issuer with a higher interest rate when the tenure exceeds a specified period and mitigates interest rate risk. For instance, ARA Asset Management’s 5.2 per cent Singdollar perp carries a hefty coupon step-up on its seven-year anniversary.”

Cons

Interest Rate Risk

Given the indefinite horizon of perps, the cash flows are highly sensitive to interest rate fluctuations. If rates rise, perp investors are likely to suffer capital losses, because their cash is stuck in a perp paying a lower interest rate.

Liquidity Risk

There is not a particularly active market for secondary trading in perps, so holders could take a hit as they may not be able to sell on their investment.

Credit Risk

The tenure of perps is uncertain, so it is possible that the fundamentals of the issuer will eventually change, sometimes for the worse. If so, it could have an adverse impact on the issuer’s ability to meet payments to the perp holders.

Furthermore, there is a payout hierarchy if a firm goes belly up and perps are a long way down the totem pole.

Perp holders come after creditors, secured debt holders and subordinated debt holders, so there is a greater risk that they will take a haircut on their investment if the issuer liquidates, says Ms Teh.

“If the issuer goes into financial trouble, the seniority of a security takes on an important role,” notes Mr Ang.

“When a company liquidates, the holders of subordinated debt (such as a perp) will get paid only after senior creditors have been paid first. In exchange for this risk, (perps) offer a higher yield,” he adds.

Call Risk

Perps may have a call provision, which allows the issuer to redeem the securities at a certain redemption value. This is an option, not an obligation. Generally, issuers exercise the call provision when it best suits them, but not necessarily the holders.

Say, interest rates fall. There is a high chance that issuers will call back perps that carry a high interest rate, because they can then issue a new instrument with a lower rate.

As for investors, there is no upside for them because the price of the perp will likely be capped by the redemption value on the next call date.

Worse still, the redemption value may actually be lower than the price they initially forked out for the perps.

Reinvestment Risk

Issuers can call back high-coupon-rate perps when interest rates are low, but this subjects investors to reinvestment risks.

This is because after calling back high-interest perps, the issuer may then re-issue a new perp at a lower rate. Investors, meanwhile, will have to invest the redemption proceeds when interest rates are lower.

Cash Flow Risk

With some perps, the issuer may be able to defer all or part of the distribution payments without triggering a default.

Ms Teh warns that investors may end up holding perps that do not pay distributions and with little prospect of the principal amount being returned.

No Voting Rights

Perps do not come with voting rights, unlike ordinary shares, so holders do not get a say on any aspect of the issuing firm.

Possible Outcomes For Holders When Firm Shuts

When a company is wound up, it ceases to operate and the assets are sold off. The sale proceeds would be paid to creditors and shareholders.

Perp holders usually rank behind senior creditors but ahead of ordinary shareholders, so you could lose some or all of your investment, depending on how much money is left from asset sales.

An issuer may structure its debt into different classes – senior and junior. Usually, secured debt is classified as senior debt while unsecured debt is classified as junior or subordinated debt.

Among investors, senior debt is paid first, followed by junior/subordinated debt.

Its important to check where your perps will be ranked. In general, perps are junior/subordinated debt. Whether you and other perp holders get repaid all or part of your initial investment depends on the amount of proceeds available from the liquidation.