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Key risks to consider when investing in corporate perpetuals
THE struggle of Hyflux - which has leveraged on its strong name recognition and market support to issue S$900 million of retail perpetuals across two tranches - has raised legitimate questions on whether retail investors are properly equipped to understand and evaluate the risks involved in buying non-vanilla products such as corporate perpetuals.
The Singapore-dollar bond market has developed significantly over the last 15 years. Once dominated by institutional investors, it has now evolved into a deeper market supported by a broader cross-section of investors, from real money accounts like insurance companies and asset managers to hedge funds and high net worth individuals. With the advent of retail bonds over the past decade, retail investors have also entered the picture. The nature of issuances in the SGD market has also shifted towards higher yielding products.
In this regard, corporate perpetuals have proven to be very popular with SGD bond investors. This particular product typically offers attractive yields - distributing a certain payout at intervals.
Unlike vanilla bonds, however, corporate perpetuals are often structured such that issuers have great discretion to defer payments (i.e. no guaranteed fixed payments) and have no legal obligation to redeem the principal. Because of their higher risks, corporate perpetuals ought to be issued by high-grade corporate entities though in some instances they are not.
Last year , corporate perpetuals accounted for 16 per cent of aggregate issuance volumes.
What are corporate perpetuals?
Corporate perpetuals (also referred to as corporate hybrids) are considered a quasi-equity instrument within a company's capital structure.
Companies typically issue corporate perpetuals for several reasons. One key reason is to achieve accounting equity treatment in accordance with International Financial Reporting Standards (IFRS). This means that the issuance will be treated as equity (instead of debt) on the company's balance sheet and related interest expense is reflected after (instead of before) the net profit line in the income statement. In addition to IFRS accounting equity, corporate perpetuals can also be structured to achieve financial covenant equity, rating agency equity and/or MAS regulatory equity (for REITs).
While more expensive than senior, unsecured debt, corporate perpetuals are still considered a more cost-effective way of raising capital for a company compared to issuing equity. In addition, the interest payments can be fully tax deductible and the issuance does not dilute the ownership of existing shareholders.
Key structural risks to consider
Compared to senior, unsecured bonds, corporate perpetual issuances can vary much more in their issuing structure, depending on what equity treatment the company is trying to achieve. Hence, it may be more challenging for an investor to determine where the key structural risks reside.
In their most basic form, corporate perpetuals are used to achieve IFRS accounting equity. To do so, the instrument must adhere to two criteria: it cannot have a maturity date (hence perpetual) nor any contractual obligation to pay. However, it would be impossible to market a fixed-income instrument where the investor may never receive either the principal (due to the perpetual maturity) or coupons (as these can be deferred at the issuer's discretion). To make them more attractive and marketable, corporate perpetuals are typically structured with investor-friendly features, such as issuer call option, coupon step-up, interest rate reset, coupon pusher, dividend stopper etc.
The best way to think about a corporate perpetual is as an instrument that sits on a debt-equity spectrum; whether it leans more towards the debt or equity end depends on how debt-like the structure is.
For example, if there is a large 500 bps coupon step-up at the first call date, then the issuer is highly incentivised to call back the security on the first call date, making the instrument more debt-like. Conversely, if there is no coupon step-up, the instrument would less likely to be redeemed and would be more equity-like. All things being equal, the more debt-like the instrument is, the lower the structural risk and correspondingly, the lower the coupon rate it offers.
In general, issuers try to optimise the structure of the corporate perpetual to enhance marketability within their ratings or regulatory framework.
Whilst structural risk is important to understand, it still comes down to analysis of credit risk. Due to the nature of the instrument, the ideal issuer of a corporate perpetual should have a high degree of cashflow visibility, and be in a stable sector (Reits, utilities, telecoms etc).
If we turn the spotlight on Hyflux, it is easy to see how an investor evaluating the company could be seduced by its track record of outperformance in the equity markets, its excellent market reputation highlighted by a series of high profile projects in Singapore and abroad, and its entrenched market position in a highly strategic industry. Yet, the discerning investor would also note that underneath the veneer of consistent profits, there was a concerning pattern of increasingly negative operating cashflows starting from FY2010. This was funded by a mix of bank borrowings, (ever larger) capital market issuances and asset disposals. When Hyflux issued its first corporate perpetual in 2011, the warning signs were less obvious. However, by 2014 and before Hyflux had issued three of its four corporate perpetuals, this trend had become quite evident.
While the recent downturn in the power sector may have triggered the recent woes of Hyflux, its consistently negative operating cashflows represented an early and repeated red flag on the elevated credit risks associated with the company, which no combination of investor-friendly structural features can mitigate.
The SGD bond market has certainly punched above its weight over the last 15 years, and part of the credit for the vibrancy of the SGD market is due to the regulators adopting a market-driven, disclosure-based regime.
But the current concerns about Hyflux are a reminder that the path to success is never a straight line, and enhanced investor education and sophistication are absolutely critical to creating a more robust and sustainable market going forward.
- The writers are CFA charterholders who volunteer with CFA Society Singapore on advocacy issues.
Hyflux has responded to this article to say that the negative operating cashflows in FY2013 - FY2015 are in part due to investments into infrastructure projects during the construction stage being classified as Operating Cash Flows instead of Investing Cash Flows under the accounting standard INT FRS 112 service concession arrangements. In the past few years, Hyflux has been investing into the Tuaspring project in Singapore, the Qurayyat project in Oman and the TuasOne Waste To Energy project in Singapore. These investments are all classified as Operating Cash Outflows.