Beware risks of corporate perpetual bonds

Published March 19, 2012


Focus on hybrids of stronger names with high credit ratings: Bank of Singapore


By MINDY TAN


WITH the corporate perpetual bond market within the emerging-market (EM) bond space growing substantially, investors need to be aware of the risks associated with hybrid perpetual bonds, says Bank of Singapore.


Of the two types of corporate perpetual bonds in the market (senior unsecured perpetual bonds and hybrid perpetual bonds), the latter - which has both equity and credit-like features - is the only type issued by Asian corporates to date.

The key risk for hybrid perpetual bonds lies in its structure, which differs materially from one another, the bank said in a recent note.

Said Bank of Singapore head of credit research Todd Schubert: 'The structure of the bond partially determines the pricing of hybrid perpetual bonds, and investors need to determine the fair value of the bond in light of the strength of the bond structure.'

He said: 'Certain hybrid bonds have very weak structures (for example, Nobel perpetual) and such weaknesses could create significant price volatilities in the market, which tends to be exacerbated in times of market weakness. In addition, the investors may not receive certain coupons and/or principal back from the issuer for a prolonged period.'

A key risk associated with hybrid perpetual bonds is the ability of the issuer to not pay coupon since non-payment of coupon does not trigger an event of default; the deferred coupons are generally cumulative.

In addition, in case of liquidation or bankruptcy, the recovery for hybrid bondholders could be minimal since these bonds are ranked just above common equity holders.

In certain cases, hybrid bonds could contain no covenants or a very relaxed set of covenants, which gives lower-level protection to bondholders. In addition, given that such bonds have no maturity date, holders are heavily exposed to interest rate risks, said Mr Schubert.

Within the hybrid perpetual space, Bank of Singapore recommends that investors focus on stronger names with high credit ratings given that this limits investors' exposure to credit risks of the issuer (for example, Hutch and SingPost); add bonds with strong structures; and add issuers for whom hybrid perpetual bonds may be the only instrument available in the market since these bonds tend to perform well due to their scarcity.

'We think that a small allocation to hybrid perpetual bonds in an EM bond portfolio is justified to enhance yields or to gain exposure to rare issuers,' said Mr Schubert. 'We would recommend clients to allocate a maximum of 5 per cent of the aggregate portfolio to such instruments, depending on the risk profile of the client.

'High allocation to these types of hybrid corporate perpetuals could significantly increase the overall risk profile of a bond portfolio.'

Between the two perpetual bond types, Mr Schubert said the bank prefers senior unsecured perpetuals - typically issued by Brazilian companies, with the exception of Energisa - since investors are only exposed to credit and duration risk in these perpetuals.

Clients are recommended to allocate approximately 10 per cent of their EM bond portfolio in this asset class.

Commenting on the perpetual bond market, Mr Schubert said: 'During periods of market weakness, we believe that these securities will likely exhibit heightened volatility and performance could be correlated with the underlying reference equity.'

Anecdotal evidence suggests that private banking clients are the key investors of perpetual bonds, given that the perpetual nature of the bonds and the equity features in hybrid perpetual bonds typically deter institutional investors from participating in these deals, noted Mr Schubert.

In the case of the recent Genting deal, 78 per cent of the bonds were allocated to private banks. In the case of Mapletree and SingPost, the allocation for private banks was 67 per cent and 60 per cent of the total deal respectively.

Brazilian companies remain the key issuers of corporate perpetual bonds in the EM space. Since 2010, 14 Asian corporates have issued perpetual bonds, amounting to $9.4 billion. Bank of Singapore estimates that there is approximately $14.4 billion worth of EM corporate perpetual bonds outstanding in the market, excluding the bank perpetual bonds. - BT