Steep selling seen for recently-issued "fixed-for-life" USD perpetual bonds

A higher risk-free rate has hurt bond market performance

The recent election of Donald Trump as the next US President has triggered a rout in global bond markets, with benchmark US Treasury yields driven to the highest levels in a year (See Chart 1) in response to the aggressive fiscal plans that may be enacted under the new President, triggering expectations of a more rapid pace of US interest rate increases going forward. This broad sell-off has particularly impacted the prices of longer duration bonds – bonds with longer maturities and/or lower yields and coupon rates – with the steepest selling seen especially for "fixed-for-life" perpetual bonds. As seen on Table 1, fixed coupon USD perpetual bonds issued this year have returned an average of -6.07% MTD (as of 25 Nov 16), while USD corporate bonds registered a more modest decline of -2.41% over the period.

Chart 1: US Treasury Bond Yields

Table 1: Selected "fixed-for-life" USD perpetual bonds

Rising rates highlight the risks of "fixed-for-life" perpetuals

Why have these (mostly) investment-grade rated perpetual bonds performed that poorly? Investors should note that "fixed-for-life" perpetuals can work heavily against investors in a rising interest rate environment. As these bonds do not have coupon reset features which are common to most other perps, issuers do not face a penalty in terms of paying a higher coupon rate (when rates rise) if they do not redeem the bonds on its first call date. Among the fixed coupon perps listed in Table 1 include Solvency 2 compliant subordinated debt issued by European insurers such as AXA SA, Allianz SE, Prudential PLC and Zurich Insurance.

We note that the recent uptick in US Treasury rates has brought these perps further below par, and the "fixed-for-life" coupon structure means the bonds are now viewed on a yield-to-maturity basis rather than on a yield-to-call basis, as there is a disincentive for issuers to redeem the bonds early (or at all!) if benchmark rates continue on its upward trajectory. Therein lies the significant duration risk for "fixed-for-life" perpetuals, where investors are exposed to significant interest rate risk if the issuer doesn't call the bonds. Conversely, if interest rates decline materially, investors face reinvestment risk as issuers would choose to redeem the bonds early and refinance at a lower rate.

Li & Fung "fixed-for-life" perpetuals have underperformed

Amongst the various "fixed-for-life" USD perpetuals, Li & Fung Ltd's LIFUNG 5.250% Perpetual Corp (USD)s have been the worst performer this month, and are currently quoted at an ask price of 87.96, having declined a hefty -12.5% since its issuance earlier this month. These bonds are currently trading at a yield-to-call of 8.3% (OAS: 524bps) although we think that this is less representative of the returns that investors will receive, given the unlikely event of an issuer call for the issue in November 2021. The yield-to-maturity of 6.15% (based on an assumed maturity date in 2049) at current levels is probably a more representative measure for the LIFUNG 5.250% Perpetual Corp (USD)s, which represents an OAS of 314bps – 345bps over UST (utilising the 15Y and 30Y UST rates for reference).

In the comparison of credit spreads, this puts it closer to where Li & Fung's other outstanding perpetual bond issue (LIFUNG 6.000% Perpetual Corp (USD)) is currently priced; the notes are quoted at ~308bps over UST based on its YTC of 4.1%, with a higher likelihood of a call in May 2018 given its coupon reset rate of 5YR UST + initial spread (5.276%) + step-up margin (0.25%), which provides some protection for bondholders in the event of a non-call. Consequently, we note that LIFUNG 6.000% Perpetual Corp (USD)s are still trading above par at 102.9, having declined a more modest -1.58% MTD.

What this suggests is that investors are still not receiving much of a spread premium for gaining exposure to the "fixed-for-life" LIFUNG 5.250% Perpetual Corp (USD)s, despite the asymmetrical risk-reward profile of the structure. On a relative value basis, the LIFUNG 6.000% Perpetual Corp (USD)s look more attractive vis-à-vis the "fixed-for-life" LIFUNG 5.250% Perpetual Corp (USD)s, which should, intuitively, require a much wider spread versus its peer.

Cheung Kong Infrastructure Holdings' CKINF 5.875% Perpetual Corp (USD)s stand out in Table 1 as the only "fixed-for-life" bond issued in 2016 still trading above par even as prices declined -3.21% MTD, with investors seeming to price the issue based on a call in March 2021 (issuer will likely call back the bond if it trades above par as YTW will be below the 5.875% coupon rate). This could be due to Cheung Kong's track record of redeeming its fixed coupon perpetuals, having called CKINF 6.625% Perpetual Corp (USD) in March 2016 (6 months after its first-call date) and more recently, the CHEUNG 5.125% Perpetual Corp (SGD)s in September on its first-call date, where SGD swap rates were edging higher.

Are "fixed-for-life" perpetual bonds a buy?

As alluded to above and also in an earlier article, the asymmetrical risk-reward profile of "fixed-for-life" bonds means that gaining exposure to these bonds may be worthwhile only if investors anticipate interest rates to be at a "goldilocks" situation where they do not deviate too much from current levels, allowing investors to lock in decent yields and moderating durational and reinvestment risk. At current levels, seeking exposure to selected "fixed-for-life" perpetual bonds could also be a proxy bet for declining interest rates – with most of these bonds trading at discounts-to-par. Any significant reduction in interest rates, however unlikely, would incentivize issuers to redeem these bonds (at par), posting strong returns for investors buying at current prices. Nonetheless, we are of the opinion that global bond yields have bottomed and that we still could be in the early stages of rate rises. We hence continue to favour short-duration bonds – shorter-dated and higher-yielding bonds – to mitigate against further interest rate rises. Investors looking for an additional yield-pick up over short-tenor bullet bonds may consider perpetual bonds with coupon reset features. One such perp in the SGD bond universe is Vibrant Group's VIBGSP 7.350% Perpetual Corp (SGD)s (YTC: 21.3%) , which we have previously highlighted. Investors may also consider First REIT's FIRTSP 5.680% Perpetual Corp (SGD)s as as well as BAERVX 5.750% Perpetual Corp (SGD)s, which are trading at YTC of 5.76% and 5.6% respectively, both sporting potential tenors of just under five years.