Since our publication of Perpetual Series 6 titled “Picking up nickels” on Sept 11, 2020, in which we cautioned against chasing certain perpetuals which have higher noncall risks, the steam-roller has run ahead with a sharp rise in rates which impacted prices. Year-todate, total returns of most perpetuals are negative, with the simple average price down about 4.5%. The decline is in line with the rest of the SGD corporate bonds, which in turn has outperformed those in the Asia dollar and USD space.
Aside from rising rates, prices have fallen due to the increase in extension risk. Thus far, eight perpetuals remain outstanding past their first call date in the SGD corporate perpetual market. Aside from those whose issuers are in default or restructuring (for example, HYFSP 6.6212%-PERP, EZISP 0.25%-PERP), the remainder were not called because it was more expensive to issue a replacement perpetual, in our view. Replacements are more expensive given that spreads in the market have increased, which increases the cost of issuance (distribution rate of a perpetual is usually based on adding a spread to a reference rate).
What drives issuers to redeem their perpetuals
Traditionally, issuers were expected to redeem the perpetual at the first call date. This is because in a traditional perpetual structure, there will be features that incentivise issuers to call, such as stepups which result in an increase in distribution rates should the issuer decide not to redeem the perpetual at its first call date (which makes it expensive for the issuer to retain the existing perpetual). In addition, a good structure should include resets which allow distribution rates to be adjusted based on prevailing interest rates at the first call date (and at periodic dates subsequently).
However, there may be little economic incentive for issuers to redeem the corporate perpetuals facing first call within the next 12 months even if we disregard the fact that credit spreads have widened. Such issuers include those which issued perpetuals that are not structured with step-ups (such as perpetuals issued by REITs which typically do not have step-ups to meet the Monetary Authority of Singapore’s guidelines for these to be considered as non-debt). In addition, several are not structured with resets at the first call date, which provides an economic disincentive for issuers to redeem given rising interest rates.
Looking beyond economics as a driver of non-call risks
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While economics (it is more expensive to issue a replacement perpetual) is most likely a necessary condition leading issuers to miss the first call, there are other factors at play in determining if an issuer will do so.
The need (or lack of need) to include perpetuals as part of the capital structure would be a major driver. For example, GENSSP 5.125%-PERP was called in 2017 most likely because Genting Singapore had excess cash — it has not issued a replacement perpetual since. For more recent examples, First Real Estate Investment Trust offered holders to tender their perpetuals, citing the need to optimise its debt capital structure (albeit opportunistic given the tender price at 70% of principal which is 30% below par). We also observed the redemption of WINGTA 4.08%- PERP even though there was no step-up on the first call date, likely because Wing Tai Holdings was in a net cash position.
Issuers will also need to consider reputational impact. We believe this was the main driver resulting in the calls being exercised for SWIBSP 9.75%-PERP and EZRASP 8.75%-PERP, even though both issuers subsequently went into debt restructuring. After all, reputation can be easily lost but takes years to build.
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As such, despite no strong economic incentives for issuers to exercise the call, we believe a few of the corporate perpetuals (though not all) facing first call by 2023 will likely be redeemed. That said, even if the decision of the call at the first call date is driven solely by economics, it is not a one-off decision for issuers to exercise the call; beyond the first call date, it is more akin to a binomial decision where issuers have the option on when the call should be exercised.
Therefore, even if the perpetuals were not exercised at first call, there could be sufficient economic incentives that will drive the eventual call of the perpetual and it will be useful to think with reference to yield to eventual call.
Opportunities remain, but be prepared to hold
Despite rising rates and widening spreads, we think investors may not need to shun perpetuals as yields have risen significantly. We see potential upside for several perpetuals where rewards may outweigh the risks (specific recommendations are published in OCBC Monthly Credit View). That said, given the precedence and recent trend of non-call (with the latest being STHSP 3.95%-PERP), holders should be ready to hold perpetuals in the portfolio indefinitely.
Diamonds are forever, perpetuals may be likewise.
Wong Hong Wei, Ezien Hoo and Andrew Wong and are credit research analysts with OCBC Bank’s Global Treasury Research & Strategy
