To issuers of perps, cash is king

The proliferation of bond offerings of late has drawn interest in a big way from both fund managers and retail investors.

In the past month, blue-bloods such as United Overseas Bank, French lender Societe Generale and Canadian insurer Manulife Financial Corp have waded into the market here to raise hundreds of millions of dollars.

Even less well-known companies such as Aspial Corp, Perennial Real Estate and Oxley Holdings have successfully clinched big sums from bond offerings.

But what is particularly eye-catching is the revival in interest in perpetual bonds, or perps. These are bond-like instruments that offer their holders a fixed payout but no voting rights.

In quick succession, firms such as UOB, Mapletree Logistics Trust and Societe Generale pushed out perps issues on the wholesale market, which is confined to fund managers and high-net-worth investors.

Water-treatment specialist Hyflux went one step further and sold perps to the retail crowd. This helped it raise $500 million - a bigger sum than its market capitalisation of $444 million.

This has led to some market pundits wondering if these firms had discussed with each other the best way to raise capital and came to the conclusion that selling perps was the way to go.

For perp buyers, the big attraction is the mouth-watering interest payments - or coupon - promised as keeping the money in the bank gives them almost zero return.

But that attractive payout comes with a big catch. Unlike a straight bond, in which both the principal and interest must be paid according to a fixed schedule, a perp issuer has the discretion to withdraw coupon payments under certain circumstances without triggering a default on his other debts. He also gets to decide when he has to repay the principal to the borrower.

There is a further attraction: Under current accounting rules, perps are considered as equity, rather than debt, on a company's balance sheet.

So if a company borrows money by issuing perps to repay existing debt, one of its financial ratios - debt-to-equity - will actually improve. This is because the debt would be reduced after being paid off by the money raised from perps, while the equity portion is concurrently being boosted by the new perps.

On the flip side, unless a company can get a better return from the money it raises from selling perps, the high coupon payments it has to foot will eat into the profit that it makes.

And if its profit falls, that would have an adverse impact on another two numbers which an investor looks at - the price-earnings ratio and the return on equity.

For the company's shareholders, there is a further concern. Unless a company pays the coupon on the perps, it will not be able to declare an ordinary dividend to shareholders.

Now, considering that issuing perps is an expensive way to raise funds and there are some drawbacks in issuing them, why do companies press ahead?

For an answer, it is instructive to look at two previous periods - 2008 and 2012 - when perps enjoyed a similarly roaring popularity among issuers. Quite by chance, like now, these years coincided with the Olympics Games.

As many would recall, 2008 was when the global financial crisis erupted with such a fury that it almost wrecked the world's banking system, leaving a trail of destruction that included the collapse of American investment bank Lehman Brothers.

But just months before Lehman's demise, the three local banks - UOB, DBS Group Holdings and OCBC Bank - were sufficiently mindful of the oncoming storm to raise huge sums from issuing preference shares, an instrument similar to perps, to bolster their capital base.

Then in 2012, perps made a comeback as another financial crisis - this time in Europe - soured investor sentiment, given concerns of a possible break-up of the euro zone and the destruction of the euro.

This was in the wake of the drama then unfolding in Greece, where an upcoming election triggered fears that the electorate would vote for a government that would take them out of the euro zone rather than accept austerity measures.

Like now, the benchmark Straits Times Index in 2012 was languishing around 2,800 points. The sluggishness of the Singapore economy at that time had also sparked concerns, with growth in the second quarter shrinking 0.7 per cent compared with the first.

Fast-forward to 2016 and some of the concerns that prevailed in 2012 are still with us, including uncertainty over the US economic recovery and the prospect of a hard landing in China. Instead of Grexit, we now have Brexit - the prospect of a British vote to leave the EU next month.

However, there is a big difference between now and 2012. Then, the US central bank was firmly on the pedal, pumping the equivalent of US$80 billion (S$110.5 billion) a month into the financial market with its massive bond-buying programme.

But the US Federal Reserve minutes released last week suggested that financial conditions in the US had brightened sufficiently for policymakers to contemplate raising interest rates again in the next few months.

If it does so, this would be in keeping with its March agenda, where it indicated that it would limit the number of rate increases expected for this year to just two quarter-point moves.

But any incremental increase in interest rates by the Fed - no matter how small - would be greeted with trepidation. This is in view of the widespread mayhem encountered in global stock markets early this year after the Fed's quarter-point rate hike in December - its first in almost a decade.

Under such trying circumstances, it is not surprising to find companies adopting the view that a bird in the hand is worth two in the bush as they scramble to get as much cash as they can get their hands on before the Fed tightens the screws on liquidity- and that includes selling perps to raise funds.

What should investors do? If they take the cue from perp issuers, they should be keeping some cash handy. There is no telling when it may come in useful. In uncertain times such as now, cash is the undisputed king.

This article was first published on May 30, 2016.
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