It is not uncommon to see companies dishing out bonds that are sliced into very small denominations to attract retail investors. During the past three months or so, we see at least 2-3 per month. These bonds are certainly not short of subscribers. With a bond rate of 5%-6%, it is certainly very attractive given that the fixed deposit (FD) rate of about 2.0% at the very most. The expectation of impending interest rate hikes certainly push companies, especially those that are in need of funds, to dangle out bonds as quickly as possible to beef up their war chests. In particular, perpetual bonds are special type of bonds that do not have maturity date, and that is where the term perpetual is derived.
While a lot of focus has often been placed on the expected returns, investors often forgot about the terms, especially, the risks that come along with it. First and foremost, when there is no maturity date, theoretically it means that it is up to the company to decide when to redeem back the bond, or not at all. It is unlike a conventional bond that a company has to take pain to ensure that the exact capital is paid back to bondholders at maturity. In other words, a bond holder is in no position to get back his capital unless he sells the bond in the open market, which is very often very illiquid and may have to sell at a discount if one needs the money urgently. Of course, if a bondholder is prepared mentally that that could be the situation in future, then at least the first part of the hurdle is solved.
Given that bondholders do not have much control over the maturity, we should assume that we would not get back our capital at all to be very conservative. That means that we have to rely on coupons distributed by the company quarterly, semi-annually or annually, whatever declared, to generate the returns that we need. This also put the issue of irrevocability a point of contention here. If the bond is irrevocable, it also means that the company is not obligated to make good the coupons that were missed out. While this may affect the company’s credit-worthiness, it also means that retail investors have no recourse on the missed out coupons should such as situations occur. This literally means that the pay-back against the initial investment is stretched even further. Of course, I do not mean that companies would purposely want to do that as they definitely would want to continue to be in the good books of the banks and the investing public, but that term gives them a huge protection should such a crunch occurs. Personally, I would believe that companies would time and again review their account books to assess if they could redeem back those bonds given that interest premium over the prevailing bank interest rate is not a trivial amount in terms of the quantum that they need to pay the bondholders.
That brings me to the last point on why, in the first place, the companies want to raise bonds at a higher interest rate instead of borrowing from the banks. In all likelihood, before the companies carry out such an exercise, they have already had discussions with their banks. Generally, banks lend to companies via secured lending, which means that companies have to present some collaterals as a form of guarantee against the borrowing. That enables the banks to lend at a lower interest rate. However, it may be a situation that most of the company assets have already been pledged to banks, and the banks find the risks too high to swallow, and the company has to turn to the investing public for funds. This means that retail investors are taking on a higher risk as such lending are generally unsecured, and, of course, in the event of liquidation, it is almost certain that bondholders would lose at least part of their capital. Needless to say, this would also affect the common stockholders as well. And that is why share price usually falls whenever a bond, be it a conventional or perpetual bond, is issued.
Perhaps, when we enter a perpetual bond, our mind is never to have it redeemed. In other words, our intention is to continue to have a passive income, hopefully forever. Before you do that, maybe you may wish to review the table in the link to really know your breakeven point of your investment. For investing public like us, the best way to measure it is to assess in terms of number of years required for us to re-cope our initial investments.. This table applies to perpetual bonds, REITs or any investment that you wish to keep till perpetuity. Think about it, if the bond is irrevocable, then the payback gets even longer. Further, with the impending interest rate hikes, it is almost certain that bond prices (or even REIT prices) will fall. That will further discourage us from selling the bonds and shift us into holding the bonds longer. The point is does it worth to keep our investment till perpetuity?
So, look at the risks as well, not simply just the expected returns.
Brennen has been investing in the stock market for 26 years. He trains occasionally and is a managing partner for BP Wealth Learning Centre. He is also the author of the book – “Building Wealth Together Through Stocks” which is available in both soft and hardcopy.