Markets

QuickTake

Why ‘Perpetual Bonds’ Are Rocking

Credit Markets
By Lorretta Chen and Ameya Karve
November 9, 2022 at 1:51 PM GMT+8

From

The bonds may be “perpetual,” but the headaches they caused in Asia in early November were
immediate: An obscure South Korean insurer bucked convention by initially opting not to pay
investors back, in a wakeup call that a wave of firms could follow suit. That sent prices on many
“perps” tumbling by a record. Signs that the Federal Reserve would guide interest rates even
higher than expected worsened the rout. The turmoil was a reminder to global investors that
securities that are unremarkable parts of the financial plumbing in normal times can present
unexpected risks when pressures build.  

1. What are perpetual bonds?

In theory, they’re bonds that a borrower can choose to never pay off. Perpetual bonds, or perps,
are issued by companies without a maturity date, or with very long tenors such as 50 years. In
contrast, the tenor of many corporate bonds globally falls somewhere around only 8 years. But in
reality, investors generally expect perps to be paid back after just several years. That’s because
most of the securities have so-called call option dates, when the borrower can decide to redeem
them. Most of the time, that’s just what they do. Investors hold perps primarily because they pay
higher interest than normal bonds, to compensate for the risk that borrowers could go against that
convention, making them more akin to stocks paying regular dividends. 

2. What is a call date? 

When a perpetual bond is issued, a date is set at which the issuer has the option to redeem the
bond at a specific price, usually par value. If the issuer chooses not to buy the bond back, it needs
to start paying a higher interest rate to the holder than before the call date. Call dates are usually
set to land a few years after issuance and thereafter at regular intervals, with the payments
ratcheting up if the bond isn’t redeemed. Over the last 14 years, ever since the 2008 financial crisis
ushered in a lengthy era of declining or low interest rates, investors had grown accustomed to
borrowers opting to buy back the bonds at the first call date, because the issuer could often secure
cheaper financing than what they would have had to pay after the reset. 

3. What are the risks of perpetual bonds?

In normal times, they’re not thought of as risky, but two features embed the possibility of big
losses. For one thing, the prices of a perpetual bond are more sensitive to changes in interest rates -
- and thus more volatile -- than comparable notes of shorter duration. A jump in interest rates that
makes existing bonds with lower rates less valuable has a bigger impact on a note that could be
locked in for decades than on one that matures in a year, for instance. Secondly, perps are a type of
subordinated or junior subordinated debt, meaning that in case of a default they stand to be wiped
out before forms of senior debt like public bonds or bank loans. In this sense, they’re akin to
contingent convertible bonds, known as CoCos -- a cross between a bond and a stock that was
designed to prevent a repeat of the taxpayer bailouts of the 2008 financial crisis.

4. Why do borrowers and investors like them? 

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Borrowers have varied reasons for issuing perpetual notes. Banks and other financial companies
often use perpetual bonds to raise Additional Tier 1 (AT1) capital, a lender’s first line of defense
after equity against financial shocks. They can either convert to equity or be written down to
increase a lender’s equity base when the company faces financial distress and its capital ratio falls
below a certain level, minimizing any systemic pain. Non-financial borrowers may opt for this debt,
despite a relatively higher cost, as they technically don’t have to repay the principal -- or at least
not for many years. While perpetual bonds are riskier than conventional notes due to the
uncertainty of the maturity date, the higher yields are an appeal to investors. The call option on
the note, meaning investors can potentially get their principal back, is another reason some buy
them. Additional options such as the increase in interest if not called by the issuer, and conversion
of a fixed rate into a floating one after an initial period, also can make their returns more attractive
than regular notes.

5. What’s happened to perpetual bonds this year?

Inflation took off as the Covid pandemic waned and Russia invaded Ukraine, disrupting energy and
other commodity supply lines. In response, the Fed and other central banks have dramatically
pushed up interest rates to try to rein in rising prices. That changed the calculus for borrowers in
deciding whether to buy perpetual bonds back at their call date: As interest rates rise, making it
more expensive to buy and replace a perp, even the stepped-up rate triggered by skipping the call
can be lower than what the market rate to refinance now would be. November’s turmoil was
triggered when two life insurers in South Korea did just that, deciding to delay buying back their
notes, the first such move since 2009. In the market drop that followed, notes issued by Kyobo Life,
one of Korea’s top insurers, and AIA Group Ltd., the largest insurer in Hong Kong, were hit along
with Korean, Hong Kong, and Chinese banks. While one of the Korean insurers that had initially
delayed backtracked days later, sparking a broader rebound in the securities, the asset class is
still facing greater scrutiny as more call dates loom. An Australian regulator warned borrowers
not to redeem capital securities early if they need to pay higher interest to issue new ones.

   

6. What’s the impact of that?

It’s not unknown for borrowers to skip a call option, though it’s rare for banks. Investors have
never liked that, because who wouldn’t want to get paid earlier rather than later, particularly when
you could reinvest that money in securities with higher interest rates? A longer maturity on the
bond also means more uncertainty. In the context of a global downturn in bond markets, the
prospect of many borrowers skipping calls has already shaken investor confidence. Such decisions
also could affect future borrowing costs of the issuer: Investors will reward borrowers who exercise
calls as it will be seen as a sign of them being well capitalized. Those that don’t could be punished --
forced to offer higher rates to attract buyers -- on concerns about their liquidity. At least $3.7 billion
of perpetual bonds by financial firms in Asia Pacific will become callable before the end of this
year, according to Bloomberg-compiled data.

COMPANY CALL DATE  AMOUNT OUTSTANDING

Chiyu Banking Corp 11/29/2022 $250,000,000

King Talent Management  12/04/2022 $400,000,000

Commonwealth Bank of Australia 12/05/2022 $100,000,000

FWD Group 12/15/2022 $750,000,000

Bank of Chongqing Co. 12/20/2022 $750,000,000

Charming Light Investments 12/21/2022 $250,000,000

China Construction Bank Asia 12/29/2022 $1,000,000,000

CMB Wing Lung Bank 12/29/2022 $130,000,000

The Reference Shelf

From the archive: A QuickTake on contingent convertibles, also known as CoCo bonds, and
another on the time the Treasury considered ultra-long bonds

In 2019, How Santander Call Confusion Is Roiling $340 Billion CoCo Market

An explainer on what is happening in Korea’s local credit market

A Bloomberg Intelligence report on Asia perpetual bond risk, an outlook for South
Korean banks AT1s, and a company outlook on AIA

— With assistance by Harry Suhartono, Dorothy Ma, Yuling Yang and Catherine Bosley

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