When Hong Kong borrowers started executing fixed-for-life perpetuals towards the end of 2016, they initially met strong demand from fund managers searching for additional yield pick up in a declining interest rate environment.
However, institutional investors’ enthusiasm began to wane fairly quickly in 2017 once they calculated that the bond bull market was topping out. This left private banking investors to pick up the slack when a wave of Hong Kong property developers led by Sun Hung Kai, Cheung Kong and Nan Fung hit the market in the late spring of that year.
Those investors must then have spent the whole of 2018 kicking themselves, or ruing their lack of market knowledge, after yields shot up into the stratosphere.
When Asian bull markets turn, it is often the spread performance of China’s high yield property credits, which hits the headlines. Yet the sector’s dramatic yield swings pale in comparison to the performance of perpetuals like Sun Hung Kai’s 4.45% non-call three bond issued in May 2017.
Despite carrying a single-A rating, the bond hit a yield-to-worst of 26.23% in early December 2018 according to S&P Global Market Intelligence data. However, investors who were smart enough to position themselves for the Federal Reserve’s next interest rate cycle have done very well since then given the bonds are now trading around the 4.391% level.
The term fixed-for-life implies duration, but perps are generally short-dated instruments and Sun Hung Kai may well call its 2017 deal when it has the option to do so this May if markets continue heading in their current direction.
Ironically, the Hong Kong property developer may also now be able to achieve even tighter pricing than it did in 2017. Such is the “new normal” as investors find themselves re-adjusting to ever longer and lower interest rate cycles, interspersed with shorter up-cycles.
And Sun Hung Kai may not be alone in calling its bond, since Cheung Kong and Nan Fung both utilised perpetual non-call three structures in the spring of 2017. Those fixed-for-life issues with longer-dated call options falling due in 2021 and 2022, including Li & Fung’s 5.25% deal callable November 2021, have not recovered to the same degree.
So far this year, there have been a string of well-received perps. The asset class is back in vogue again and some market participants believe that, this time, it may stay that way.
Dealogic data shows that 11 borrowers raised $9.582 billion in G3 currencies during January and February. If issuers maintain the same momentum for the rest of the year, then the region is on course for a record-breaking 2020.
Issuance may top 2017’s $44.28 billion issuance via 70 deals. And there has already been one deal in March after Metallurgical Corp of China (MCC) completed a $400 million perp non-call three offering on the 5th.
As Carla Goudge, HSBC’s head of debt syndicate for Asia Pacific, puts it, “demand for perpetuals is very strong right now. Even when volatility shut down US and European primary bond issuance in late February, Asia was still printing well-received benchmark deals for Bank of Communications (Hong Kong) and Hysan Development.”
Indeed, perps attracted some of the biggest order books of the month. Standouts include: Singapore’s DBS whose $1 billion Additional Tier 1 (AT1) deal attracted a $5.5 billion order book; plus the Philippines’ SMC Global, which garnered $4.9 billion for a $600 million deal. Then there was Bank of China, which topped the lot in absolute terms with $6 billion of demand for its own $2.82 billion AT1 deal right at the end of the month.
All three bonds came from well-respected tier-1 borrowers. However, given growing virus-related nervousness, none of the deals could be considered full-on bond bull market trades, the tagline historically attached to perps.
They demonstrate that perps can be mainstream trades and even bear market ones too. For as Citi’s Asian bank capital specialist, Lee-Shin Koh, explains. “Everything is in a state of flux as the bond market grapples with two difficult big questions: just how much worse is the coronavirus going to get and will central bank stimulus work or not?”
STRUCTURAL DIVERSITY
Does this mean that perps can become more of a product for all seasons? Part of the answer depends on the kind of structures, which are used and for which type of borrower since the instrument is a necessary part of the capital structure for banks.
For most corporate issuers, the ideal structure is fixed-for-life with a very short-dated call option. If interest rates go up, they have a very cheap cost of funding in perpetuity and if they go down, they can call the bonds quickly and re-finance.
From an investor’s perspective, the ideal transaction is one that either incorporates a big-step up so it is clear what the bond’s “real” duration is, or has a longer-dated call option. What they do not want to get stuck with is a bond that may not get called if rates go up.
So far this year, most of the deals have had five-year call options. However, MCC highlighted how transactions are becoming more issuer-friendly with its three-year one.
The deal also had a 300bp step-up. By contrast, when it executed its last dollar-denominated deal in 2018, the $500 million 4.95% fixed rate bond had a step up to 733bp over Libor after three years.
The new deal, nevertheless, attracted a $2.4 billion order book and traded up after it broke syndicate.
At the other end of the maturity curve is China Communications Construction, which raised $1.5 billion in mid-February. Its deal had two tranches and it was the one with the longer seven-year call option, which has performed best since then.
The decision to include it was also driven by the issuer's preference, not the investors'.
HSBC’s Goudge comments that CCC’s longer-dated tranche underlines how Asia has a far more diversified bond market than outsiders sometimes give it credit for. “In the past, there's been an assumption that the Asian perpetual market is short dated,” she stated. “But the market has far more maturity and depth than that.”
For corporates, perpetuals are all about balance sheet management. Their equity accounting treatment means they can help with de-leveraging targets, which makes them especially appealing to Chinese state-owned enterprises.
They can also help a company to protect and maintain its credit rating: the main driver for Hysan, Bharti Airtel and UPL’s recent deals.
Augusto King, head of Asian debt capital markets at MUFG, explains that, “perpetuals are a strategic product. They cost more than senior debt so there needs to be a concrete reason for a borrower to want to issue them.”
He also adds that not all borrowers will be able to access the market. “Investors are selective and typically like borrowers with well-defined senior debt curves,” he commented. “This means they already have an established investor following and it’s easier to establish a perps’ fair value relative to senior debt.”
Owen Gallimore, head of Asian credit strategy at ANZ, thinks the asset class is “relatively attractive” at the moment. In a March 3 research report, he noted that senior perps are averaging a 110bp premium to bullet bonds and subordinated perps are trading 150bp over. Back in December the senior/bullet spread for China SOE perps was half this level.
“Yields of bullets might be low for China investment grade in general," he said. "In the long term, either perp yields go down, or bullet yields go up.”
BANK CAPITAL
This year’s AT1 deals for Bank of China, BoCom and DBS highlight how the offshore bank capital market is also picking up again after a lacklustre 2019 when Chinese banks turned onshore for funding.
China’s other big commercial banks, ICBC and CCB, are also readying offshore AT1 deals, a process almost certainly boosted by the strong reception and pricing that Bank of China achieved. The latter had been planning its Ba1/BB+/BB+ rated deal for a while: its main dilemma being whether to plough ahead with a physical roadshow, or wait out the virus. In the end, it decided to push it out while markets were liquid following conference calls with investors.
DBS took a far more opportunistic approach. After a year concentrating on Tier 2 debt, it picked a particularly opportune time, before volatility kicked in, to set a new global record tight with the 3.3% coupon on its AT1 deal.
Bankers expect a number of re-financings in 2020. But no one is sure what declining global growth means for banks’ capital adequacy ratios and desire or need for more capital instruments to bolster them.
“There are two sides to this argument,” Citi’s Koh explained. “On the one hand, banks may need to come to the market because problem loan and impairment rates are rising. But on the other, there’s less loan growth so they don’t need capital to fund growth but purely to replenish capital that’s being retired.”
One thing tier-1 banks do not want to experience are any shockwaves from spread widening of tier-3 bank AT1 bonds if the latter banks come under severe capital pressure thanks to the virus’s impact on growth (or lack of). However, regulators are already starting to show some forbearance across the board.
The Hong Kong Monetary Authority, for example, had set an unofficial June deadline for its domestic systemically important banks to get their Total Loss Absorbing Capital, or TLAC, plans in place. This has now been extended to the end of the year.
