Perpetuals: aggressive terms don't scare investors
It's been a record year for perpetual bonds across Asia Pacific, as investors shrug off default risk and the prospect of interest rate rises to snap up bonds with no maturity date.
In one of the most eye-catching examples of the trend yet, Far East Horizon, a China-based financial leasing company, sold its second perpetual bond in less six months on Monday. What's notable is that the bond structure gives no incentive to the company to buy back the bond for 20 years.
Priced to yield 5.6%, the $400 million Reg S transaction was seen by some fixed-income investors as the embodiment of a rising trend in Asian debt markets, with companies increasingly migrating down the credit rating spectrum and investors barely batting an eyelid.
Perpetual bonds – which share some characteristics with equity because they have no maturity date and in theory do not ever have to be paid back to holders – have accounted for roughly 15% of all Asian G3-currencies bond issuance so far this year, according to Dealogic. That figure is a record as investors look beyond credit ratings for more yield.
In the latest deal by Far East Horizon, the Hong Kong-listed company sold a subordinated bond without providing a step-up feature for 20 year, as against the five-year step-up more commonly found in perpetuals. The move could be interpreted as exploiting investors’ greed for higher returns since adding step-up features to perpetual bonds incentivises issuers to redeem bonds in order to avoid paying higher interest payments.
“I am not sure if some investors may misinterpret it as a five-year risk, given this is a perpetual bond without a step-up in 20 years, which is fairly aggressive in my view,” a Hong Kong-based fund manager told FinanceAsia, the sister publication of AsianInvestor. With credit spreads tight globally and US interest rates likely to rise over the next 12 months, Far East Horizon would probably have little incentive to redeem the bond on its first call date five years from now, the fund manager added.
A spread broadly measures how much more a corporate issuer pays to borrow than a government does. Different companies pay different spreads depending on their credit ratings and financial health, as well as on the maturity of the bond. In general, credit yield spreads have narrowed sharply in recent years due to the heavy bond buying undertaken by leading central banks to help spur economic growth after the global financial crisis almost 10 years ago. But these ultra-loose monetary policies could slowly end now the US Federal Reserve has begun trimming its $4.5 trillion portfolio of assets.
“Investors now need to figure out how central banks' retreat from monetary easing will affect the bond market,” said a second fund manager in Singapore. “In my opinion, there will be a huge difference in the debt market over the next 12 months as central banks move away from pumping money into the system in an attempt to halt bubbles in equity and property markets."
In addition to the gradual withdrawal of liquidity in the market, Standard & Poor's warns of increasing default risk in China, which could spook professional investors to readjust their portfolios as Beijing pushes to rein in debt growth.
“We expect the number of corporate defaults to increase as China unleashes more measures to reduce financial risks, pushing up funding costs further,” Christopher Lee, an analyst at S&P, wrote in a note on Monday. “A jump in defaults could shut credit markets for weak issuers and significantly increase overall funding costs.”
Far from perfect
In the Far East Horizon transaction, the company, which is rated BBB- by both S&P and Fitch, garnered about $1 billion of orders from investors at peak level, according to a syndicate banker running the deal. The final issuance size of $400 million was slightly smaller than what market had previously expected, suggesting some disagreement among investors on pricing.
On Monday, the lead bankers – HSBC, Standard Chartered and UBS – went out with initial guidance at the 5.75% area, before pricing the deal at par to yield 5.6%.
In terms of fair value, bankers used Far East Horizon’s outstanding senior perpetual bond as a major valuation benchmark. The 4.35% unrated bond, which is callable in 2022, was trading at a yield of 4.32%, implying the company has paid roughly a 130 basis point pickup for its latest subordinated perpetual bond.
The premium over the senior perpetual was paid for its subordination risk and an option to defer interest payment at the issuer’s discretion, as well as a long-dated step-up, which will kick in 2037.
Under Fitch’s non-financial corporate rating methodology the subordinated debt was rated two notches below its BBB- senior ratings, as the bondholders of the subordinated bonds take higher risk than its senior perpetual bondholders in the case of a default and because of the deferred dividend feature.
In the secondary market, the new perpetual bond traded above water at a cash price of 100.125 to yield 5.571%, or about 3bp tighter, according to market data.