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They offer regular payouts at fixed rates, but are not like regular bonds
By Yasmine Yahya
20 May 2012
They might sound a bit complicated but perpetual securities have been selling like hot cakes over the past few months as retail investors queue up to get a slice.
And who can blame them? In an economy where interest rates are near zero and stocks are becoming more volatile, we are all thirsting for simple financial products that can bring us steady returns.
But there is a catch: Regulators are saying that the ‘perps’, as they are commonly known, might not be as simple as many assume.
The Monetary Authority of Singapore (MAS) warned investors last Wednesday that perpetual securities are not like regular bonds and, therefore, are riskier.
An earlier Reuters report citing unnamed sources said that the MAS had held two informal meetings with bankers in recent weeks as it is worried that local retail investors might be taking on too much risk or buying perps without a full understanding of the product.
The Sunday Times spoke to several experts to nail down the nature of this new kid on the investment block.
What is a perpetual security?
A perpetual security acts much like a bond, giving the holder regular payments at a fixed rate.
For example, the perpetual security issued by Genting Singapore last month will pay investors 5.125 per cent of their investment a year.
And like bonds, the company that issues the perps will likely redeem them at a certain point - in Genting’s case, in 10 years’ time - and return the initial sums to investors.
But note that word ‘likely’.
Unlike with bonds, the company is not legally obliged to pay out a regular distribution. It can choose to defer a payout, and do so indefinitely.
The company also has a right to never redeem the bonds - hence the term ‘perpetual’.
Perpetual securities also rank lower than bonds in terms of their claim on the company’s assets.
If a firm collapses and has to be wound up, bondholders are paid first from whatever assets that have been liquidated.
Holders of perpetual securities would be next in line - if there is any cash left.
Investors holding preference shares come next and finally, holders of common stock - again, if anything is left in the kitty.
Perpetual securities also take precedence over common stock when it comes to dividends and distributions. The company must distribute payouts to perpetual securities and preference shares holders first, before it can declare a dividend for its shares.
DBS Bank’s head of fixed income Clifford Lee notes: ‘As long as the company doesn’t pay coupons on the perpetual security, it can’t pay dividends to shareholders. If it decides that it wants to pay dividends on its common shares, then it also has to pay out all the deferred coupons accumulatively.’
That means a company has to pay out its latest distribution plus any distributions that it had previously missed.
What are the risks of perpetual securities?
First, the company might defer all distributions and choose not to redeem the perpetual security, which means zero returns on your investment.
It is also harder to sell a perpetual security than a common or preference share.
There is also the risk that an investor might not be able to get out of the investment when he wants to. These investments typically do not have as much liquidity as shares or equities.
‘Compared to conventional straight bonds which have maturity dates, investors in perpetual securities are subject to risks in the secondary market which are mainly market, credit, liquidity and price risks,’ Mr Marcus Teo, the head of HSBC Singapore’s high-net-worth channel, says.
Third, there is interest rate risk.
If interest rates rise rapidly over the next several years, the distribution rate on existing perpetual securities would not look attractive any more.
In such a situation, the issuing company might also be less motivated to redeem the perpetual security.
And at that point, it is likely that the value of the perpetual security would fall, he adds.
‘With bonds, you could still look forward to getting your capital back.
‘Say you bought a bond with a 2 per cent coupon and then interest rates rose. The value of the bond would fall but when it is nearing the maturity date, people would still buy it because they could buy the bond at a cheap price and make money when the company returns the principal amount.
‘But with perpetual security you can’t look forward to that as they may not call it back and return the principal.’
Given such an environment, most people would be looking to sell while few would want to buy - so investors would be stuck with their perpetual securities.
What are the advantages of perpetual securities?
HSBC’s Mr Teo has a straightforward answer: ‘Compared with equities, perpetual securities tend to be less volatile and provide a regular stream of income.’
No doubt, the payout rates being offered by the companies issuing perpetual securities definitely beat the interest rates investors would get in a savings account.
And given that the stock market is becoming ever more volatile, being able to receive regular fixed payouts a few times a year does sound attractive.
Of course, there is that risk that the company might just decide to defer all distributions indefinitely.
However, Mr Lee of DBS says this is unlikely with big firms.
‘The ones which have issued perps so far are top-tier names, such as Global Logistic Properties, SingPost and Hyflux,’ he notes.
‘If they defer their coupon payments, their stock price will plummet because a coupon deferment means no dividend, so it’s quite punitive for them to defer the payouts.’
This means it is vital for investors to choose perpetual securities very carefully, he adds.
‘Investors must only look at companies whose credit they are very comfortable with.
‘They should also check the dividend history of the company - if it has been paying regular dividends over many years, that gives a lot of assurance that the company will continue to pay a dividend, and therefore, the chances of it deferring a coupon are lower.’