Thursday, 17 May 2012

Risk of Perpetual Bonds

Perpetual bonds had recently been attracting a lot of attention not only from retail investors but also from regulators. A year after Hyflux offered the first perpetual bond to the public raising S$200m, Genting Singapore follow suit and had recently raised S$500m. Both perpetual bonds had offered attractive coupon rate of 6% and 5.125% respectively with a possible step up to even higher yield, if it is not called after certain year. However, disturbingly, following the public offer by Genting Singapore, MAS had voiced out its concern and subsequently issued a word of warning over the excessive risk taking by retail investors who may not fully understand the risk associated with this class of investment product.

To understand the risk of perpetual bond, we first need to know what are they. Perpetual bonds are essentially bonds without maturity date. But unlike vanilla bonds, it is possible for the issuer of perpetual bonds to defer payment for a prolonged period without defaulting, but deferred coupon is generally cumulative, so as long as the company does not fold, you will still be entitled to your coupon eventually. Another feature of perpetual bond is the option for issuer to NOT redeem (call) the outstanding perpetual bonds indefinitely. Any investors who wish to close their position can only do so by selling them in the secondary market, subjecting them to price fluctuation risk.

To determine the value of a perpetual bond, we need to find out the par value, discount rate and coupon. Suppose, initially a perpetual bond was issued at a par value of $100 with a coupon rate of 5%. The coupon is given by 0.05*100 = 5 and the discount rate is given by (coupon/par)*100% = 5%. We can then determine the value of bond  based on the following formula:

Bond value = Coupon/Discount Rate
Suppose again, there is a rise in interest rate by 100bps, the discount rate (for simplicity purpose) would rise by the same amount to 6%. Based on the formula above, the new value of bond will be given by 5/0.06 = $83.33, a 16.7% fall in value of the bond. Thus, the value of bond is highly sensitive to interest rate. But surely, if interest rate fall by 100bps, then the bond price would rise by 25% isn't it? Unfortunately, this might not be the case for perpetual bonds. Firstly, interest rate is at an all time low now, the only way interest rate would move is up, hence investors may sit on their loses for an extended period of time if (and very likely) the issuer does not call back the bonds. Secondly, even if interest rate do fall, the callable option by issuer will limit the rise in value of the perpetual bond. When interest rate fall, the value of bond will increase, however, with a lower interest environment, issuer may call back the perpetual bonds at par value and issue new bonds at lower discount rate. Taking into account of such possible scenario, this rise in perpetual bond price is usually discounted by certain amount. 

Local bankers said the risks have been escalated because private bankers, the main takers of the recent perps, were buying on the margin - sometimes using leverage granted by the lead managers themselves. Some purchases were done on 100 per cent margins, said one foreign banker.  - Strait Times, 15 May 2012.

What the quote is essentially saying is that, when interest rate rises quickly, the perpetual bond loses its value rapidly. Those private bankers who are invested using leverage will receive a margin call where he may be forced to sell off the bonds, adding to the selling pressure and further depressing the bond value, leaving retail investors strangled on a pile of losses.

In summary, perpetual bonds has all the potential downside but very limited upside. Personally, I find some REITs and blue chips offer much better yield to risk ratio. However, I'm not saying that perpetual bonds are to be avoided at all cost. Different people with different investment objective might find perpetual bonds fit into their portfolio nicely, but if you are investing in perpetual bonds, try to buy from companies with strong brand name and high credit rating and preferably one with a history of consistent dividend payment. Lastly, do read their prospectus and evaluate all the possible risk before putting your hard earned money into any investment.

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