On Tuesday, investors were reminded of the dangers of investing in perpetual bonds at a time record low interest rates as Indian conglomerate Reliance Industries (Baa2/BBB) sold a senior perpetual dollar-denominated that offered very few guarantees that the principal will ever be repaid.
Even as several fund managers and credit analysts warned of the lack of protection to creditors, the company was able to sell an US$800m perpetual at 5.875%, the tightest an Asian company has achieved on a senior secured perp. That yield was still some 50bp higher than what the company's 2040s were offering in secondary markets.
However, savvier investors, such as fund managers, stayed away from the transaction, which was mostly sold to private banking accounts, traditionally considered less sophisticated.
On their first day of trading, the bonds traded as low as 96.35 after pricing at 100.00, making for one of the worst performances for an Asian dollar investment-grade bond this year.
The reason for the drop, according to fund managers, was the bond's very weak structure. "If they fail to call the bonds in the fifth year and 30-year US Treasury yields go to 5%, the yield on these bonds would go to 8%," said one portfolio manager.
The problem is basically on the call, or when the company is allowed to buy back the bonds. Investors in perpetual bonds often assume that the bonds will be redeemed on their first call date, which in Reliance's case is in 2018. However, from the company's standpoint, it only makes sense to buy back the perpetual notes if it can refinance them more cheaply.
That happened to be the case for the perps issued before 2007 since benchmark rates dropped steadily and touched record lows last year.
But this time is different. Yields on benchmarks such as US Treasuries and German Bunds are on the rise and most analysts think that they will be much higher in five years than they are now. "[The trend in rates] means it will be quite challenging for longer-dated bonds going forward," said a portfolio manager in Singapore. Hence, the possibility that Reliance will be able to refinance its bonds at a lower yield is remote.
That is why fund managers were suspicious of Reliance's perpetuals. If Treasury rates are higher, corporate yields are probably going to be much higher than they are now. So it is unlikely that Reliance will want to buy back the bonds by incurring more expensive debt.
In fact, fund managers have been demanding that companies include a significant yield hike after the first call date to give them safety that if the bonds are not redeemed. At least then their returns will match the new corporate yield reality.
Reliance did not include that and institutional investors stayed mostly away from it. But this was just the latest example of how savvier investors are shunning perpetuals without a significant step-up.
Similar notes from Chinese developer Agile Properties sold a few weeks ago at 100.00 are still trading around 95.00. Meanwhile, perps with step-ups are doing just fine.
"The argument to buy perps hinges on three things: absolute yield, rates direction and your bet on the company calling them or not at the call date," said one credit analyst.
Without the step-up, said investors, the perpetual has very little upside and a lot of potential downside. The lack of a maturity date means that the perps could behave like 30-year bonds. That means a significant potential drop in case benchmark rates rise. The longer the maturity on a bond, the bigger the price drop for every percentage point of yield rise.
On the flip-side, in the unlikely event that rates are lower five years from now, Reliance has the option to call the bonds and refinance them more cheaply, eliminating the upside for investors. "If rates collapse they can take the bond back," said a portfolio manager in Hong Kong. "It is entirely the company's prerogative to call them, which makes this deal very opportunistic," said the Hong Kong manager.
Besides the technical arguments, there is also the issue of what happens if Reliance does not call the bonds 2018. This problem was evidenced when Deutsche Bank did not call a lower tier 2 bond in December 2008. The decision caused the prices of similar bonds to drop up to US$10. It also sparked a 30 basis points widening in the European iTraxx subordinated financial index to about 237.5 basis points, while Deutsche Bank's subordinated credit default swaps widened by about 45 basis points.
Given the lack of incentive to call, Asian investors were predicting a similar outcome with Reliance. "Five years from now, imagine 30-year US Treasuries are at 5% and Reliance does not call the bonds, you will see the yield on their bonds jump to 8%," said another portfolio manager in Singapore who did not buy the bonds. "These private banking investors (who bought this) are going to get burned," another one said.