This article first appeared in The Edge Malaysia Weekly on April 4, 2022 - April 10, 2022

WHILE perpetual bonds are hybrid in nature, sharing both the characteristics of bonds and equities, more often than not, they are classified as a type of equity rather than debt on the balance sheet of issuers.

As there is no contractual obligation from the issuer to redeem the instrument as there is no maturity date, the holders or investors of perpetual bonds, or sukuk, are usually long-term investors such as insurance companies or institutions.

Back in 2013, property developer Paramount Corp Bhd became the first non-government-linked company (GLC) in Malaysia to issue perpetual bonds. Prior to that, the issuers were predominantly GLCs such as Malayan Banking Bhd and Malaysian Airline System Bhd (now known as Malaysia Airlines Bhd).

Since then, there have been a slew of non-GLC corporates issuing perpetuals such as IJM Land Bhd, Mah Sing Group Bhd ,Tropicana Corp Bhd and Yinson Holdings Bhd (via subsidiary Yinson TMC Sdn Bhd), and perpetuals also continue to be favoured by GLCs such as Maybank, CIMB Group Holdings Bhd and Boustead Holdings Bhd.

But are these instruments a boon or bane for corporates issuing them? Charanjeev Singh, founding partner at boutique corporate finance advisory firm NewParadigm Capital Markets, says it depends on how the instrument is structured and its covenant.

“Perpetuals actually started out in a big way for the banking industry to meet the Basel III capital requirement rules. Since the nature of perpetual bonds is that the issuer, and not the investor, is the one who decides at which point of time these instruments need to be paid back, these bonds can then qualify for synthetic equity treatment.

“For issuers, it is a boon because it allows them to have flexibility in their capital management, as they are allowed to defer their interest payments. [Depending on how the bond is structured,] however, there are certain covenants that kick in once there is a deferment of payment of perpetual bond interest. For example, a company may not be able to pay dividends on their ordinary shares because, by ranking, ordinary shareholders fall below perpetual bondholders,” Charanjeev tells The Edge.

Some perpetual bonds may, over time, may be too expensive for an issuer, such as those with step-up interest features, whereby the interest rate on the paper keeps increasing by a certain percentage every year if the call option on the bond is not exercised.

“If there is a huge stepped-up interest, the rating agencies would be more inclined towards classifying the instrument as a debt instrument and will assign a low percentage of equity treatment, because the step-up feature imposes a lot of costs on the issuer, especially when the rates are high and the issuer does not choose to call the bond at that point in time,” says Charanjeev.

An example of the stepped-up interest feature is Boustead’s perpetual sukuk, for which the profit rates could step up to as high as 10.6% this year — more than 650 basis points higher than the prevailing 10-year Malaysian Government Securities’ yield of 3.926%.

While most issuers of perpetuals have taken the “unrated” route and have accounted for the perpetual issuance as 100% equity on their balance sheets in line with the Malaysian Financial Reporting Standard 132 “Financial Instruments: Presentation”, rating agencies have a different perspective on this, says Charanjeev.

“For example, RAM Rating Services Bhd in its criteria and methodology stipulates various factors to be considered before allowing any equity credit to any perpetual issuance,” he explains. “To put the entire discussion on equity credit for perpetual bonds rating methodology in perspective, you could say weak, moderate or strong scores equal to accounting for 25%, 50% and 75% [respectively] of equity credit in perpetual bonds. As perpetual securities rarely fully replicate the core characteristics of pure equity, to fully account for equity credit is unlikely to be common in practice.

“Another interesting point to note is [while] most issuers of perpetual bonds, or sukuk, in Malaysia have taken the unrated route and [have therefore classified their] perpetual securities as equity because the payment of any distribution or redemption is at the discretion of the issuer, [if they had opted for the] rated route, at best, RAM would have accorded a 50% equity credit.”

Interestingly, the Securities and Exchange Commission of Thailand in 2020 had stated that companies planning to issue perpetual bonds must comply with Thai Accounting Standards (TAS 32) that have strict stipulations, wherein most perpetual bonds are most likely to be classified as a liability, a deviation from their current status as equities.

The Securities Commission Malaysia (SC) in its 2021 annual report noted an instance of non-compliance with approved accounting standards in relation to the failure to reclassify certain perpetual sukuk from equity instruments to financial liability when the listed company no longer had an unconditional right to avoid the redemption of the perpetual sukuk.

On a question from The Edge on what action was taken against this particular company for the breach of accounting standard, SC said it had issued written warnings.

“SC had issued written warnings for the breaches after considering, among others, the remedial measures undertaken by the plc (public-listed company) prior to the release of the relevant financial statements.

“Perpetual sukuk is recognised as an equity instrument when it meets the conditions of an equity instrument under MFRS132, in particular paragraph 16. When a plc no longer has an unconditional right to avoid redeeming a perpetual sukuk, it may need to be reclassified as a financial liability. The assessment for the classification of a perpetual sukuk as either an equity instrument or a financial liability must be based on the facts and circumstances at that particular point of time,” SC says.

Charanjeev further explains that perpetual securities are always rated a few notches below that of their issuers.

“Perpetual bonds are never rated at the corporate rating; they are usually rated two or three notches below the rating of the issuer. For example, if a particular corporate is rated ‘AAA’, the perpetual will probably be rated ‘AA3’ or ‘A’, depending on the structure itself.

“Perpetual bonds from a legal perspective are subordinated to the rating of the issuer as there are no fixed terms of payment; as such, the rights of perpetual bond creditors are subordinated to any senior bondholders,” he says.

While perpetuals in general are favoured by property developers in Malaysia, in Australia, it is the mining companies that are the largest issuers.

Charanjeev says that in 2002, the Australian tax authorities decided that interest payments on perpetual bonds were synthetically equity, and therefore not tax deductible.

“As perpetual bonds have no fixed terms of repayment, the Australian tax authority decided that it [did] not qualify as debt, and thus interest payments made on perpetual debts were not deductible. [The ruling also applied retrospectively], thus whatever income tax that [the issuers] had claimed before had to be clawed back and paid to the Tax Commissioner in Australia,” he says.

At present, interest payments on perpetuals that are structured as a debt instrument to raise funds for business operations and reflected as such in the books of the issuer are tax deductible in Malaysia, says Tricor Malaysia chairman Dr Veerinderjeet Singh.

“Of course, if one structures perpetual bonds but the key characteristics are such that one could interpret the instrument as being similar to equity, then technically, no tax deduction is applicable,” he says.

Veerinderjeet adds that the characteristics of such instruments need to be analysed before determining their tax treatment.

“The tax authorities can and will look into such matters, usually in tax audits, and in the end, everything depends on the facts and the nature of the transaction,” he says.

Perpetual bond issuances have been trending downwards from pre-pandemic levels as the number of perpetual bonds issued in 2019 was 18, falling to 17 in 2020. Last year, there were a mere seven issuances, notes BIMB Investment fixed income analyst Ganageaswaran Arumugam.

He says: “This most likely reflects a lower appetite among investors as the risk-reward dynamics do not justify the partaking in perpetual bonds in the current economic climate.

“Companies that currently have perpetual bonds on their balance sheet face higher refinancing costs as benchmark movements across government securities have been on an upward trend since the start of the year, thus raising the cost of refinancing for existing borrowings.

“This is because while perpetual bond tenures are infinite in nature, it is common that they have ‘coupon reset dates’ most commonly at the five-year mark from the date of the issuance. This is usually part of the call option embedded in the perpetual bond. At the reset date, the coupon or borrowing cost is repriced at the initial spread plus benchmark rate. Given that benchmark rates have been steadily increasing, issuers would face a higher refinancing rate in the future.”

For investors, Ganageaswaran says, the benefit of investing in perpetual securities is their attractive rate of return as this reflects a higher risk of default by virtue of their repayment ranking in the balance sheet.

“Perpetuals are usually more suitable when economic prospects are buoyant as this improves the repayment ability of issuers and therefore lowers the issuer’s risk of default,” he says.

Charanjeev believes perpetual bonds are not expensive “debt” but cheap “equity”, and it is all about lowering companies’ weighted average cost of capital and boosting shareholder returns.

“For investors, though, the high yields on these subordinate instruments have to compensate for a lot of risk and uncertainty. In a bear credit market, they might perform far worse than any other debt instrument in an issuer’s capital structure and, in certain circumstances, even worse than equities.

“Corporates can go bust. They could walk away from obligations when they feel the risk of doing so is less than the damage of meeting them. As a comparison, in the US, some of the corporate issuers of redeemable and perpetual securities suspended payments. Investors of perpetual securities in Enron, WorldCom, Global Crossing and so on recovered the same as equity holders, which is nothing,” he says.

While perpetuals may have their risks and rewards for both issuers and holders alike, corporates would need to consider whether it is the best instrument to meet their financial obligations, given the consequences to be faced in the event of a default. For investors, a proper review of the creditworthiness of the issuers should be done before investing in such instruments.

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