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Are fixed rate perpetuals diamonds in the rough?

Wong Hong Wei, Andrew Wong, Ezien Hoo and Chin Meng Tee
Wong Hong Wei, Andrew Wong, Ezien Hoo and Chin Meng Tee • 4 min read
Are fixed rate perpetuals diamonds in the rough?
Just like diamonds, perpetuals have their own version of the 4Cs / Photo: Andrik Langfiled via Unsplash
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We concluded the previous publication on SGD corporate perpetuals in this column (Issue 1051, Sept 5, 2022) with “Diamonds are forever, perpetuals may be likewise”. The permanency of perpetuals has been further enshrined as more issuers have since chosen to skip the first call of their perpetuals, including MAPLSP 3.95%-PERP, FPLSP 4.38%- PERP, GUOLSP 4.6%-PERP, ARASP 5.65%-PERP, MLTSP 3.65%-PERP (which has since reset to MLTSP 5.2074%-PERP) and EREIT 4.6%- PERP (which has since reset to EREIT 6.632%-PERP).

Economics continues to be a primary driver persuading issuers to exercise (or skip) the redemption of their perpetuals. We reiterate that perpetuals which are not structured with resets at the first call date provide an economic disincentive for issuers to skip the redemption, given rising interest rates. While resets are not a panacea, as evidenced by the noncall of MLTSP 3.65%-PERP and EREIT 4.6%-PERP, holders could take advantage of rising interest rates as distribution rates are reset higher. Another feature is the presence (or absence) or step-ups; thus far, perpetuals not redeemed on the first call date are not structured with step-ups on the first call date, aside from issuers who defaulted.

In the extremes are FFL or “fixed-for-life” perpetuals, which have no resets and step-ups on any date, and prices of such perpetuals have fallen significantly. While such perpetuals were once the charm to yield-hunters in a declining or low-interest rate environment, the rise in interest rates has dampened the appetite for such instruments, with diminished probability of call as issuers are unlikely to find a cheaper source of funding to replace such FFL perpetuals.

With the “effective maturity” extending well beyond the first call date, we think FFL perpetuals have become similar to very long-dated bonds in terms of duration. We think FFL perpetuals are also highly similar (or sometimes almost identical) to preference shares that pay regular fixed-for-life dividends. Like preference shares, FFL perpetuals rank higher than ordinary shares in liquidation, carry no voting rights and are typically cheaper for the companies to issue versus ordinary shares.

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Not all bad news? Although the current interest rate environment diminishes the likelihood of issuers exercising the call of FFLs, reinvestment risks have also reduced for such FFLs in our view, given the unchanging distribution rates and low chance of redemption in the near term.

In addition, such FFL perpetuals which are in general currently significantly underwater can enjoy upsides if interest rates fall or if credit spreads compress (when prices increase from low cash price levels). Such upside potential should be larger for perpetuals with subdued reinvestment risks (such as FFL perpetuals) relative to perpetuals where issuers are likely to exercise the call (typically at par). Should interest rates fall so significantly that the issuer could exercise the call (e.g. at par) and replace it with a cheaper cost of funding, reinvestment risks would arise though this should also lead to significant capital gains (see Figure 4 below). On the flip side, if interest rates continue to rise significantly or if credit spreads widen, FFL perpetuals may be exposed to further price downsides.

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Focusing on what’s important

For such perpetuals with subdued reinvestment risks, it will be key to assess the continuity of distributions, as perpetuals typically allow distributions to be deferred. This will be contingent on the strength of the credit profile and structures (see Perpetual Series 1: An Introduction to SGD Corporate Perpetual Bonds) which incentivise distributions to be paid out.

Especially for FFL perpetuals with no visibility of “effective maturity”, it will be crucial to assess the issuer for its ability to upkeep such distributions over the long term, such as having diversified income streams, business/assets which generate stable cashflows for the long-term and healthy credit metrics.

Given that distributions can be deferred, the willingness to pay will also be critical, which will be influenced by the presence of structures such as having deferred distributions which are cumulative and compounding (without which, issuers can defer distributions without penalty), having dividend stoppers and/or pushers (without which, issuers can pay dividends to shareholders without paying perpetual holders), and if the issuer is listed with a history of paying dividends and expectation that it will continue to distribute dividends. For FFL perpetuals which have high continuity of distributions, we think the attractiveness of such instruments will hinge on the longer-term interest rates outlook.

Wong Hong Wei, Andrew Wong, Ezien Hoo and Chin Meng Tee are credit analysts with OCBC O39 -

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