Investing in perpetual securities instead of common stocks “an opportunity cost”: Socioeconomics commentator and former banker Chris Kuan

Investing in a particular company’s perpetual securities instead of its common stocks poses “an opportunity cost”, opines retired Singaporean international banker and prominent socioeconomics commentator Chris Kuan.

Perpetual securities, or “perp” notes, typically pay “a higher coupon than ordinary bonds” due to an absence of “a final maturity period”, he added, in addition to having a lower rank compared to “ordinary bonds in getting residual value in a default”.

“Most perps have a reset date, usually 5 years from issuance where the issuer can redeem the notes at its discretion every 5 year. Usually perps have the coupon rate increased, i.e. stepped up if the notes are not called at the call date.

“Whether the issuer call or redeem the notes nearly always depend on the subsequent movement in the issuer’s cost of refinancing.

“These subsequent movement are affected by the financial performance of the issuer but it can also be affected by changes in bond yields which are outside the control of the issuer,” he noted.

Thus, Mr Kuan elaborated, should a company issue perps at 6 per cent, its cost of refinancing in five years prior to the call date of the perps will go up to around 8 per cent, which leaves “little reason for the issuer to call the bonds” in the first place.

“However, if the perps have a step up coupon to, say, 9 per cent, then it is very likely that the company [will] redeem the notes, because it can refinance itself at 8 per cent.

“If the cost of refinancing were to fall to, say, 4 per cent, then it is also very likely the issuer will redeem the notes, because it can refinance itself [at a] cheaper [rate],” he said.

Mr Kuan posed a hypothesis, suggesting that “if the reason the cost of refinancing has fallen is that the financial performance of the issuer has improved significantly such as generating a lot of net profits, then being invested in the company’s perpetual notes rather than its common stock represents an opportunity cost”.

“Why earn 6% per annum over five years on the perps when one can earn say 10 per cent total returns on the shares?” He theorised.

“When rates go up, you have an opportunity cost in that you are stuck. When rates go down, you too have an opportunity cost in that you lose a good yielding investment,” warned Mr Kuan.

Consequently, he added, “if interest rates were to fall, perpetual notes become like bonds”, in which “investors [will] get redeemed in five years”.

“If interest rates were to rise above the step-up coupon, then the perpetual notes [will] behave more like shares”, which means that “investors don’t get redeemed, and the only way they can cash out is to sell”, said Mr Kuan.

“The above contained all kinds of optionality in the rotation between debt and equity depending on subsequent movements in interest rates, which may or may not be due to the issuer’s financial performance, then one can say this is very complicated indeed.”

He also noted that in Europe and North America, “perps are almost never issued in retail sizes, and even if one has the wherewithal to invest US$200k one shot, your self invested pension account provider [will] bar you from doing so”.

“Only in Asia do we find retail appetite for perpetual notes,” Mr Kuan observed.

In a follow-up post he labels as a “mild disclaimer”, Mr Kuan refuted the suggestion that his initial post was a “detailed explanation” of the risks contained in perpetual securities investments.

He stressed that contrary to some of the responses he had received, the initial post was merely “an outline of the risks”.

“There are a lot more complications, e.g. whether perpetual notes will be redeemed by the issuer also depends on such things as the comparative cost of refinancing depending on the type of securities used to refinance, their pros and cons and how these methods of refinancing impact the balance sheet in different ways.

“This gets into the realm of specialist knowledge,” he concluded.

“Perps” carry huge risks, ranging from possibility of getting no reward for investment to difficulty in selling in secondary market

Perpetual securities carry many huge risks, which include the possibility of “perps” holders never being able to receive principal repayments due to a deferment or total absence of any calls or distributions by the company, or even due to said company’s winding up or liquidation, according to Singapore’s national financial education programme Money Sense.

“When a company is wound up, it ceases to operate its business, and the assets are sold off. The proceeds from the sale of assets would be paid to creditors and shareholders.

“Perpetual securities holders usually rank behind senior creditors but ahead of ordinary shareholders, for the return of the issuer’s assets. This means that you may lose some or all of your investment,” cautions MoneySense.

“Perps” holders are also subject to a great liquidity risk due to “an illiquid secondary market”, in addition to price risk, which will make selling their perpetual securities urgently a challenge.

An infographic explaining the nature of perpetual securities or “perps”. Source: moneysense/MAS

Such are the risks that are faced by those who have invested in the preference shares and perpetual securities of debt-ridden homegrown water treatment firm turned genco Hyflux.

B. Chua, 62, and her husband, who had lost S$6,000 and S$100,000 respectively after having invested in the firm’s preference shares and “perps”, had reportedly based their investments on Temasek’s purported endorsement of the company.

Mdm Chua, who had attended the protest at Hong Lim Park on 30 Mar, was reported by The Straits Times as saying the following day: “We invested in Hyflux because government support for the company was very strong. We invested because Temasek had invested. And Temasek must have done its due diligence.”

“When banks sold the securities to us, they told us: ‘Temasek invested, so don’t worry. And if you don’t buy, somebody else will’ … Investors went in because it was a national asset,” added Mdm Chua, who had also noted that Temasek had reduced its stake in Hyflux.

Head of Public Affairs at Temasek International Stephen Forshaw wrote in response on 1 Apr that Temasek’s investment in Hyflux was “part of an initiative during the early 2000s to invest in Singapore small and medium-sized enterprises (SMEs)” in terms of supporting “their growth in promising sectors, such as water technology”.

Mr Forshaw added that Temasek “exited its Hyflux investment” following the “completion of its investment objectives”.

He stressed that the national investment company’s exit from Hyflux’s shareholding “was before 2006”, which he said was “well before the issuance of Hyflux preference shares in 2011 and their perpetual bonds in 2016”.

Temasek has not had “any investments in Hyflux since 2006”, said Mr Forshaw.

Hyflux, drowning in S$2.7 billion in liabilities as of the end of Sep last year, has given up on a “$380 million rescue package” from the Salim-Medco Group consortium, which was offered “in exchange for a 60% stake” in the water treatment company, as a result of the termination of the bailout deal with SMI.

The company reassured its shareholders earlier this month that it will “relentlessly pursue all other viable strategic opportunities” in line with its court-supervised restructuring plan.

“The company intends to work closely with the key creditor groups and relevant stakeholders to find mutually acceptable bases to enable the company to pursue such alternative opportunities,” Hyflux said.

In the meantime, Hyflux will continue to exert ownership over the Tuaspring plant, and will likely make an appeal to the High Court in a bid to extend its time to find a new potential white knight.

However, an extension of Hyflux’s debt moratorium beyond 30 Apr is dependent on whether the High Court could find “strong reasons” that demonstrate the firm’s capacity to avoid liquidation and provide its creditors with a better alternative.

“There can be no assurance that the company will be successful in securing a new investor or in finding a viable alternative to execute the restructuring,” Hyflux said.

Securities Investors Association Singapore (SIAS) chief executive officer David Gerald told The Straits Times that he has contacted Hyflux founder Olivia Lum as to whether the firm has a backup plan or safety net for its stakeholders.

Mr Gerald said: “According to her, the board will quickly re-engage with previous interested parties who had shown keen interest and were bidding for Hyflux with SMI.

“She said that the board needs some time to negotiate with interested parties and has asked that they be given some time and space to work on an alternative proposal to avoid liquidation,” he added.

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