Fixed Income Research

Educational Note
Global | Corporate Perpetual Bonds

15 March 2012
Todd Schubert, CFA
Head of Research (65) 6559 5903 todd.schubert@bankofsingapore.com

Thilina Hewage, CFA

Research Analyst (65) 6559 5846 thilina.hewage@bankofsingapore.com

Recommendation: PLEASE SEE TABLE BELOW

PLEASE SEE TABLE BELOW

Background
In recent times the corporate perpetual bond market with in EM bond space has grown substantially, with both Asian and Latin American companies tapping the market in frequent intervals. We estimate that there are approximately $14.4 billion of EM corporate perpetual bonds outstanding in the market (excluding the bank perpetual bonds). Since 2010, fourteen Asian corporates have issued perpetual bonds, amounting to $9.4 billion. In the benchmark CEMBI, there are 10 corporate perpetual bonds, with outstanding nominal value of $6 billion, approximately 3% of the index.

Market Breakdown by Issue Size

Issuance by Currency
18%

USD

SGD

82%

Source: Bloomberg, BoS Data

Brazilian companies remain the key issuers of corporate perpetual bonds in the EM space. Asian corporates entered the market over the last two years and the number of issues has grown exponentially since then. We expect this trend to continue given the historically low level of interest rates coupled with recent strength in the overall corporate bond market.

Types of Corporate Perpetual Bonds

Broadly there are two types of perpetual bonds in the market: Senior Unsecured Perpetual Bonds typically issued by Brazilian companies, with the exception of Energisa Hybrid Perpetual Bonds all the perpetual bonds issued to date by Asian corporates fall into this category

The table in the following page shows the key differences between these two types of bonds.
Senior Usecured Bonds Maturity Rating NA Ranking Coupon Coupon Deferrals Call Schedule Principal Write Dow n Recovery in Liquidation Bondholder Protection High - Below Senior Secured Creditors Fixed till Maturity Not Deferrable - Non Payment of Coupon is an Event of Default In Place No Relatively High High Similar to Senior Unsecured Debt Rating High - Below Senior Secured Creditors Fixed Maturity Senior Usecured Perpetual Bonds No Fixed Maturity Date Hybrid Perpetual Bonds No Fixed Maturity Date Generally Tw o to Three Notches Low er than the Senior Unsecured Rating

Low - Ranked Just Above Equity and Below All Senior Creditors In Most Cases there are Coupon Resets Fixed till Maturity at Certain Call Dates Not Deferrable - Non Payment of Coupon Coupons are Deferrable and are is an Event of Default Cumulative In Place No Relatively High High In Place No Low Low

Why Invest in Perpetual Bonds?

The key reason behind investment in perpetual bonds is the higher current income relative to dated bonds from the same issuer. In the table below we compare coupon and yield to maturity (YTM) for dated and perpetual bonds of seven different issuers.
CSN 10 yr Senior Bond Coupon 10 yr Senior Bond YTM Perpetual Bond Coupon Perpetual Bond YTM Yield Difference Source: BoS 6.50% 4.80% 7.00% 6.91% 2.11% Odebrecht 6.00% 5.42% 7.50% 7.20% 1.78% Citic Pacific 6.63% 7.21% 7.88% 9.00% 1.79% Braskem 5.75% 4.91% 7.38% 7.19% 2.28% Noble 6.75% 6.69% 8.50% 9.36% 2.67% GOL 9.25% 8.90% 8.75% 10.59% 1.69% Hutchison 7.63% 3.87% 6.00% 5.65% 1.78%

As shown in the table above, the perpetual bonds on average give an additional 175-200bps in yield to investors, when compared with dated bonds of the same issuer. In the case of certain issuers such as Genting or BR Malls, the only way investor can gain exposure to the name is through the perpetual bonds.

Risks Associated with Senior Unsecured Perpetual Bonds

Duration/Interest Rate Risk Rising interest rates can negatively impact the return on perpetual bonds as these securities have no fixed maturity date. in the case of Odebrecht the extra 157 yield on the perpetual bonds is to compensate the investors for the additional duration risks they undertake Call Risk A decline in funding costs due to improvements in the credit quality may induce the issuer to exercise the call. For example, Globopar has a 6.25% Perpetual bond that is callable at par in July 2015. The bond is trading at a Yield to Call of 4.3%. Given that this is roughly 200 basis points below the issue coupon it is an indication that the market believes it is extremely likely that the issuer will exercise the call option. Credit Risk-Bonds rated the same as unsecured dated bonds; credit risks equivalent.

Risks Associated with Hybrid Perpetual Bonds

As we mentioned earlier, all of the perpetual bonds issued by Asian corporates are hybrid bonds, i.e. they have both equity and credit like features. The rating agencies generally give 50% equity credit for these types of instruments. There are number of risks factors associated with hybrid perpetual bonds. Coupon Deferral Risk. A key risk associated with hybrid perpetual bonds is the ability of the issuer to not to pay coupon, if the issuer wish to do so. Nonpayment of coupon does not trigger an event of default under the terms and condition of these bonds. The deferred coupons are generally cumulative. Subordination Risk. The hybrid perpetual bonds are ranked at lowest level of the capital structure of the companies, just above common equity holders. As such in the case of liquidation or bankruptcy the recovery for hybrid bondholders could be minimal. Lack of Covenants. The hybrid bonds, in certain cases could contain no covenants or very relaxed set of covenants, which gives lower level protection to the bondholders. Duration Risk. As discussed earlier, the hybrid perpetual bonds have no maturity date and the holders are heavily exposed to interest rate risks.

Hybrid Perpetuals Its All About the Structure

The structures of hybrid perpetual bonds in the market differ materially from one another. The structure of the bond determines the level of protection bondholders receives and the probability of the issuer calling the bonds at the first call date. As such investors should place a high level of importance on the structure of hybrid perps when investing in this asset class. The structure of the bond, partially determines the pricing of hybrid perpetual bonds and investors need to determine the fair value of the bond in light of the strength of the bond structure. Certain hybrid bond have very weak structures (eg: Nobel perpetual) and such weaknesses could create significant price volatilities in the market, which tends to be exacerbated in times of market weakness. In addition the investors may not receive certain coupons and/or principal back from the issuer for a prolonged period. Investors should keep in mind that this asset class is high risk in nature and need to carefully analyze the structure before investing in the bonds. We compare key features of five hybrid perpetuals in the market in the table below.
ICTSI Bond Details Senior Rating Perpetual Bond Rating Subordination Step Up Call Structure Coupon Strucuture 8.375% Perpetual NR/NR/NR Hutch 6% Perpetual A3/A-/ANoble 8.5% Perpetual Baa3/BBB-/BBBBaa1/AGenting Sing Post 4.25% Perpetual AA-

NR/NR/NR Baa2/BBB/BBB NR/NR/NR Baa3/BBB A+ Deeply subordinated. Senior Deeply subordinated. Senior Deeply subordinated. Senior Deeply subordinated. Senior Deeply subordinated. Senior only equity holders only equity holders only equity holders only equity holders only equity holders 250 bps in Year 10 100bps in Year 10 None 100 bps in Year 10 150 bps in Year 10 Year 5, Year 10 and each Year 5, Year 10 and each Year 5 and each coupon Year 5 and each coupon Year 10 and each coupon date coupon date thereafter coupon date thereafter date thereafter date thereafter thereafter Till 2021 - 8.375% 2021-Reset to CT5+637bps+250bps 2026 onw ards - Reset to CT5+637bps every 5 yrs Till 2015 - 6% 2015-2020 - CT5+488.5 2020 onw ards - Step up by 100bps Yes, Cumulative None None Both Yes, Cumulative Yes, Cumulative Yes, Not Cumulative Only dividend pusher Yes, Cumulative None None Both Yes, Cumulative None None Both 8.5% for life 5.125% till 2022 2022 onw ards - 6.125% Up to 2022 - 4.25% 2022 on w ards: SOR10yr+219bps+150bps

Optional Coupon Deferral Mandatory Coupon Deferral Coupon Cancellation Dividend Stopper/Pusher

Yes, Cumulative None None Both

As shown in the table, Noble perpetual bonds have the worst structure among the hybrid perpetual bonds, as the issuer has no incentive to call the bonds back (due to absence of a coupon step up). In addition Noble bonds incorporate mandatory coupon deferral clause and a coupon cancellation cause, which materially lowers bondholder protection in our view. Thus its important that investors understand the key features of the bond structure in making the investment decision.

Who are the key buyers of perpetual bonds?

Anecdotal evidence suggests that private banking clients are the key investors of the perpetual bonds. The perpetual nature of the bonds and the equity features in the hybrid perpetual bonds, typically deter institutional investors from participating in these deals. In the case of the recent Genting deal for example 78% of the bonds were allocated to private banks. In the case of Mapletree and Singpost the allocation for private banks was 67% and 60% of the total deal respectively. The lack of participation of a broader investor base, especially institutional investors could materially weaken the technical support for perpetual bonds in the market.

Perpetual Bonds Portfolio Strategy

Of the two types of corporate perpetual bonds in the market, we prefer the Senior Unsecured Perpetuals, as the investors are only exposed to credit and duration risk in these perpetuals. We recommend clients to limit the allocation to perhaps 10% of the total portfolio. Furthermore, we would prefer the bonds included in the CEMBI (Braskem, CSN, Cosan, Odebrecht), as they tend to have superior technical support over the others. In the Corporate Hybrid Perpetual space, we would recommend the following: Focus on stronger names with high credit ratings. This limits the investors exposure to credit risks of the issuer and investor is predominantly exposed to risks associated with the structure. Eg: Hutch and Singpost. Add bonds with strong structure and avoid the ones with weak structures. Add rare issuers. In the case of certain issuers, hybrid perpetual bonds could be the only instrument available in the market to gain exposure to certain industry or market. These bonds tend to perform well due to the scarcity nature of the bonds.

We think that small allocation to hybrid perpetual bonds in an EM bond portfolio is justified to enhance yields or to gain exposure to rare issuers. We would recommend clients to allocate a maximum of 5% of the aggregate portfolio to such instruments, depending on the risk profile of the clients. High allocation to these types of Hybrid Corporate Perpetuals could significantly increase the overall risk profile of a bond portfolio.

Conclusion
The recent rally in the EM bond market coupled with the low interest rate environment has encouraged companies to issue Perpetual bonds. However, it is important to remember that all Corporate Perpetual Bonds are not the same. Senior Unsecured Perpetual Bonds differ from Senior Unsecured bonds only in the sense that the former do not have a fixed maturity date. On the other end of the spectrum Hybrid Perpetual bonds are intricate structures that can contain coupon deferrals and resets and are deeply subordinated vis--vis Senior Unsecured bonds. Depending on the features, these securities can be thought of as quasi-equity. From the perspective of the issuers, these bonds represent a cheap source of funding as it allows them to raise equity like capital without diluting the existing shareholders. These instruments typically receive 50% equity credit from the rating agencies.

As we shown above, there are material structural differences in the Hybrid Perpetual Bonds. The structure of the bond essentially determines the level of protection bondholders receive and this could significantly impact performance of the bond in the secondary market. We believe that investors should be aware of the idiosyncratic risks associated with this asset class and invest accordingly. Given the dominance of Private Banks in this asset class, investors must be cognizant of the potential for reduced liquidity during periods of market weakness. The Corporate Perpetual Bond market is a relatively new market with a limited sample size, so it is difficult to draw meaningful conclusions about how bonds have fared during varying periods of market performance. However, we would expect that the performance of Senior Unsecured Perpetual bonds would not differ significantly from bullet bonds of the same issuer. On the other hand, we believe that Corporate Hybrid Perpetual Bonds might exhibit many of the same trends as Bank Tier 1 Perpetuals. During periods of market weakness, we believe that these securities will likely exhibit heightened volatility and performance could be correlated with the underlying reference equity. We recommend clients to allocate approximately 10% of EM bond portfolio in to Senior Unsecured Perpetual bonds and allocate maximum of 5% of EM bond portfolio to corporate hybrid perpetual bonds.

Our Current Coverage and Recommendations

Rating Brazil CSN Cosan Odebrecht General Shopping BR Malls BR Malls GOL Rede Braskem BBB-/Ba1 BB/Ba2 BB+/Baa3 Ba3 BBBBB1 Caa3 BBB-/Baa3 7.00% 8.25% 7.50% 10.00% 9.75% 8.50% 8.75% 11.13% 7.38% 9/23/2015 11/5/2015 9/14/2015 11/9/2015 11/8/2012 1/21/2016 4/5/2011 4/2/2012 10/4/2015 101.50 105.10 104.60 103.00 105.25 108.75 83.00 42.00 102.88 6.93% 7.83% 7.21% 9.70% 6.25% 7.78% 10.59% 24.18% 7.20% BUY BUY BUY HOLD HOLD HOLD HOLD SELL BUY 4 4 4 4 4 4 4 4 4 Senior Unsec. Senior Unsec. Senior Unsec. Senior Unsec. Senior Unsec. Senior Unsec. Senior Unsec. Senior Unsec. Senior Unsec. Coupon First Call Date Offer Price Offer Yield Recom m endation Risk Rating Type of Perp

China/Hong Kong Hutch CKI BBB/Baa2 NR 6.00% 6.63% 10/28/2015 9/29/2015 103.13 94.75 5.83% 7.02% HOLD HOLD 4 4 Hybrid Hybrid

India Ballarpur NR 9.75% 8/11/2016 85.00 11.37% HOLD 4 Hybrid

Singapore Singapore Post Global Logistics Genting Mapletree A+ NR Baa3/BBB Baa3 4.25% 5.50% 5.13% 5.38% 3/2/2022 4/7/2017 9/12/2017 9/19/2017 102.25 101.55 98.89 100.38 4.54% 5.40% 5.69% 5.45% HOLD HOLD BUY BUY 4 4 4 4

Hybrid Hybrid Hybrid Hybrid Hybrid

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