Analysis |  Why 'perpetual bonds' rock credit markets

Analysis | Why ‘perpetual bonds’ rock credit markets


The bonds may be “perpetual”, but the headaches they caused in Asia in early November were immediate: an obscure South Korean insurer defied convention by initially choosing not to reimburse investors, in a alarm signal that a wave of companies could follow suit. This caused the prices of many “perps” to drop from a record high. Signs that the Federal Reserve would guide interest rates even higher than expected deepened the rout. The turmoil has reminded global investors that stocks that are mundane parts of the financial plumbing in normal times can present unexpected risks when pressures increase.

1. What are perpetual bonds?

In theory, these are obligations that a borrower can choose never to repay. Perpetual bonds, or perps, are issued by companies with no maturity date, or with very long terms such as 50 years. In contrast, the duration of many corporate bonds around the world is around only 8 years. But in reality, investors generally expect perps to be paid off after just a few years. Indeed, most securities have so-called purchase option dates, when the borrower can decide to buy them back. Most of the time, that’s just what they do. Investors hold perps primarily because they pay higher interest than normal bonds, to offset the risk that borrowers may violate this convention, making them closer to stocks paying regular dividends.

2. What is a call date?

When a perpetual bond is issued, a date is set when the issuer has the option to redeem the bond at a specific price, usually face value. If the issuer chooses not to redeem the bond, it must start paying the holder a higher interest rate than before the redemption date. Purchase dates are usually set to land a few years after issuance and thereafter at regular intervals, with payments increasing by a notch if the bond is not redeemed. Over the past 14 years, since the 2008 financial crisis ushered in a long period of low or falling interest rates, investors had grown accustomed to borrowers choosing to redeem bonds on the first maturity date. repayment, as the issuer could often obtain cheaper financing. than what they should have paid after the reset.

3. What are the risks of perpetual bonds?

Normally they are not considered risky, but two characteristics incorporate the possibility of big losses. On the one hand, the prices of a perpetual bond are more sensitive to changes in interest rates – and therefore more volatile – than comparable bonds of a shorter duration. A rise in interest rates that makes existing lower-rate bonds less valuable has a greater impact on a note that could be locked up for decades than on a note that matures in a year, for example. Second, perps are a type of subordinated or junior subordinated debt, which means that in the event of default, they risk being wiped out before forms of senior debt like government bonds or bank loans. In that sense, they are akin to contingent convertible bonds, known as CoCos – a cross between a bond and a stock designed to prevent a repeat of the taxpayer bailouts from the 2008 financial crisis.

4. Why do borrowers and investors love them?

Borrowers have various reasons for issuing perpetual notes. Banks and other financial firms often use perpetual bonds to raise additional Tier 1 (AT1) capital, a lender’s first line of defense after equity against financial shocks. They can be converted into equity or written down to increase a lender’s equity base when the company is facing financial difficulties and its capital ratio falls below a certain level, thus minimizing any pain. systemic. Non-financial borrowers can opt for this debt, despite the relatively higher cost, because they technically don’t have to repay the principal – or at least not for many years. While perpetual bonds are riskier than conventional bonds due to maturity date uncertainty, the higher yields are a draw for investors. The call option on the note, meaning investors can potentially get their principal back, is another reason some buy them. Additional options such as increasing interest if not called by the issuer and converting from a fixed rate to a floating rate after an initial period can also make their yields more attractive than regular notes.

5. What happened to perpetual bonds this year?

Inflation took off as the Covid pandemic waned and Russia invaded Ukraine, disrupting supply lines for energy and other raw materials. In response, the Fed and other central banks have dramatically raised interest rates in an attempt to rein in rising prices. This has changed borrowers’ calculus for deciding whether to redeem perpetual bonds at their call date: as interest rates rise, making it more expensive to buy and replace a perp, even the rate plus triggered by skipping the call may be lower than what the market rate would be to refinance now. The November turmoil was sparked when two life insurers in South Korea did just that, deciding to delay their ticket redemptions, the first such move since 2009. In the ensuing market slump, Notes issued by Kyobo Life, a major Korean insurer, and AIA Group Ltd., Hong Kong’s largest insurer, were hit with Korean, Hong Kong and Chinese banks. While one of the Korean insurers that initially delayed backtracked a few days later, triggering a broader rebound in stocks, the asset class is still coming under greater scrutiny as others redemption dates are looming. An Australian regulator has warned borrowers not to prepay capital securities if they have to pay higher interest to issue new ones.

6. What is the impact of this?

It is not uncommon for borrowers to ignore a call option, although it is rare for banks. Investors never liked that, because who wouldn’t want to get paid sooner rather than later, especially when you can reinvest that money in higher interest rate securities? A longer maturity on the bond also means more uncertainty. Against the backdrop of a global downturn in bond markets, the prospect of many borrowers skipping calls has already shaken investor confidence. Such decisions could also affect the issuer’s future borrowing costs: investors will reward borrowers who exercise call options, as this will be seen as a sign that they are well capitalized. Those who don’t could be punished – forced to offer higher rates to entice buyers – due to concerns about their liquidity. At least $3.7 billion of perpetual bonds issued by Asia-Pacific financial companies will become callable before the end of this year, according to data compiled by Bloomberg.

–With help from Harry Suhartono, Dorothy Ma, Yuling Yang and Catherine Bosley.

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