Perpetual bonds: the good and the bad

ALTHOUGH perpetual bonds are hybrid in nature, sharing both the characteristics of bonds and stocks, more often than not they are classified as a type of stock rather than debt on the issuers’ balance sheets.

As there is no contractual obligation of the issuer to repay the instrument as there is no maturity date, holders or investors of perpetual bonds, or sukuk, are generally fixed income investors. term such as insurance companies or institutions.

In 2013, property developer Paramount Corp Bhd became the first non-government related company (GLC) in Malaysia to issue perpetual bonds. Previous issuers were mainly GLCs such as Malayan Banking Bhd and Malaysian Airline System Bhd (now known as Malaysia Airlines Bhd).

Since then, many non-GLC companies have issued perpetuals such as IJM Land Bhd, Mah Sing Group Bhd, Tropicana Corp Bhd, and Yinson Holdings Bhd (through subsidiary Yinson TMC Sdn Bhd), and perpetuals also continue to be favored by GLCs like Maybank, CIMB Group Holdings Bhd and Boustead Holdings Bhd.

But are these instruments a boon or a curse for the companies that issue them? Charanjeev Singh, founding partner of boutique corporate finance advisory firm NewParadigm Capital Markets, says it depends on how the instrument is structured and how committed it is.

“Perpetuals actually started in a big way to get the banking industry to meet the Basel III capital adequacy rules. Since the nature of perpetual bonds is that the issuer, not the investor, decides when these instruments should be redeemed, then these bonds may qualify for synthetic equity treatment.

“For issuers, this is a boon because it allows them to have flexibility in the management of their capital, since they are authorized to defer their interest payments. [Depending on how the bond is structured,] however, some covenants come into effect once there is a deferral of perpetual interest payment on the bonds. For example, a company may not be able to pay dividends on its common stock because, by ranking, common shareholders fall below perpetual bond holders,” Charanjeev told The Edge.

Some perpetual bonds may, over time, be too expensive for an issuer, such as those with step-up interest features, where the interest rate on the paper continues to rise by a certain percentage each year if the call option on the bond is not exercised.

“If there is huge increased interest, rating agencies would be more inclined to classify the instrument as a debt instrument and assign a low percentage of equity treatment, because the increase function imposes a lot of cost on issuer, especially when rates are high and the issuer does not choose to redeem the bond at that time,” says Charanjeev.

An example of the increased interest function is the Boustead perpetual sukuk, for which profit rates could reach 10.6% this year, more than 650 basis points higher than the current yield on Malaysian government securities at 10 years of 3.926. %.

While most perpetual bond issuers have chosen the “unrated” route and accounted for the perpetual issue as 100% equity on their balance sheets in accordance with Malaysian Financial Reporting Standard 132 “Financial Instruments: Presentation” , rating agencies have a different perspective on this, says Charanjeev.

“For example, RAM Rating Services Bhd, in its criteria and methodology, stipulates various factors to be considered before granting capital credit to a perpetual issue,” he explains. “To put the whole discussion of equity credit rating methodology for perpetual bonds into perspective, you could say weak, moderate or strong scores equivalent to 25%, 50% and 75% [respectively] equity credit into perpetual bonds. Since perpetual securities rarely fully replicate the fundamental characteristics of pure stocks, it is unlikely that full consideration of equity credit will be common in practice.

Another interesting point to note is [while] most issuers of perpetual bonds, or sukuk, in Malaysia have chosen the unrated route and [have therefore classified their] capital perpetual securities because the payment of any distribution or redemption is at the discretion of the issuer, [if they had opted for the] listed road, at best, RAM would have given 50% equity credit.

Interestingly, the Securities and Exchange Commission of Thailand in 2020 had stated that companies planning to issue perpetual bonds must comply with Thai Accounting Standards (TAS 32) which have strict stipulations, in which most perpetual bonds are more likely to be classified as a liability, a departure from their current equity status.

In its 2021 Annual Report, the Securities Commission Malaysia (SC) noted an instance of non-compliance with approved accounting standards with respect to the non-reclassification of certain perpetual sukuk from equity instruments to financial liabilities when the listed company no longer had an unconditional right to avoid redemption of the perpetual sukuk.

On a question from The Edge about action taken against this particular company for violating the accounting standard, SC said it had issued written warnings.

“SC had issued written warnings for the breaches after reviewing, among other things, the corrective actions taken by the plc (listed company) prior to the publication of the affected financial statements.

“The perpetual sukuk is accounted for as an equity instrument when it meets the conditions for an equity instrument under MFRS132, in particular paragraph 16. When an SA no longer has the unconditional right to avoid redemption of a perpetual sukuk, it may need to be reclassified as an equity instrument”. Financial responsibility. The assessment of the classification of a perpetual sukuk as an equity instrument or a financial liability should be based on the facts and circumstances at that particular time,” says SC.

Charanjeev further explains that perpetual securities are always rated a few notches below that of their issuers.

“Perpetual bonds are never rated at the corporate level; they are usually rated two or three notches below the issuer’s rating. For example, if a particular company is rated “AAA”, the perpetual will likely be rated “AA3” or “A”, depending on the structure itself.

“From a legal perspective, perpetual bonds are subordinate to the rating of the issuer because there are no fixed payment terms; as such, the rights of perpetual bond creditors are subordinate to all senior bondholders,” he says.

Tax implications

While perpetuals are generally favored by property developers in Malaysia, in Australia mining companies are the biggest issuers.

Charanjeev says that in 2002 the Australian tax authorities ruled that interest payments on perpetual bonds were synthetically equity, and therefore not tax deductible.

“As perpetual bonds do not have fixed redemption terms, the Australian tax authority has decided that it [did] not be considered a debt, and therefore interest payments made on perpetual debts were not deductible. [The ruling also applied retrospectively]so regardless of the income tax that [the issuers] had previously claimed was to be recovered and paid to the Commissioner of Taxation in Australia,” he says.

Currently, interest payments on perpetuals that are structured as a debt instrument to raise funds for business operations and reflected as such on the books of the issuer are tax deductible in Malaysia, a said Tricor Malaysia President Dr. Veerinderjeet Singh.

“Of course, if you’re structuring a perpetual bond but the key characteristics are such that you could interpret the instrument as similar to stocks, then technically no tax deduction is applicable,” he says. .

Veerinderjeet adds that the characteristics of these instruments must be analyzed before determining their tax treatment.

“Tax authorities can and will look into such matters, usually as part of tax audits, and ultimately it all depends on the facts and the nature of the transaction,” he says.

Are perpetuals still in fashion?

Perpetual bond issuances have trended downward from pre-pandemic levels, with the number of perpetual bonds issued in 2019 being 18, falling to 17 in 2020. There were only seven issues, notes Ganageaswaran Arumugam, fixed income analyst at BIMB Investment.

He says: “This most likely reflects lower investor appetite, as the risk-reward dynamic does not warrant participation in perpetual bonds in the current economic climate.

“Companies that currently have perpetual bonds on their balance sheets face higher refinancing costs as government securities benchmark moves have trended higher year-to-date, increasing the cost of refinancing existing loans.

“Indeed, although the terms of perpetual bonds are infinite in nature, it is common for them to have “coupon reset dates” most often after five years from the date of issue. This is usually part of the call option embedded in the perpetual bond. On the reset date, the coupon or borrowing cost is revalued to the initial spread plus the reference rate. Since benchmark rates have steadily increased, issuers would face a higher refinancing rate in the future.

For investors, says Ganageaswaran, the advantage of investing in perpetual securities is their attractive rate of return as this reflects a higher risk of default due to their repayment ranking on the balance sheet.

“Perpetuals are generally best suited when the economic outlook is favorable, as this improves the ability of issuers to repay and therefore reduces the risk of issuer default,” he says.

Charanjeev believes that perpetual bonds are not expensive “debt,” but cheap “equities,” and are about lowering companies’ weighted average cost of capital and increasing returns for shareholders.

“For investors, however, the high yields from these subordinated instruments have to offset a lot of risk and uncertainty. In a bear credit market, they could perform significantly worse than any other debt instrument in an issuer’s capital structure and, in some circumstances, even worse than equities.

“Companies can go bankrupt. They could evade their obligations when they believe that the risk of doing so is lower than the damage that would be incurred by complying with them. By comparison, in the United States, some companies issuing callable and perpetual securities have suspended their payments. Perpetual securities investors from Enron, WorldCom, Global Crossing, etc. got the same as the shareholders, which is nothing,” he says.

Although perpetuals can present risks and rewards to both issuers and holders, companies should consider whether they are the best instrument to meet their financial obligations, given the consequences they will face if they do. of failure. For investors, a proper review of the creditworthiness of issuers should be made before investing in such instruments.

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