Exuberance boiling over in the market for perpetuals

SINGAPORE - ONE of my favourite quotes on investments comes from Sir John Templeton who once noted that bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.

This is what leads me to believe that given the moribund state of the stock market with overall daily turnover falling well below the $1 billion mark for many of the trading days in the past few weeks, there is little danger of share prices plunging for now since there are few signs of euphoria among traders.

But then I may be hunting for irrational investment exuberance in the wrong market.

There are, after all, various financial assets which an investor can pour his money into - and interest in one of them has turned red-hot.

This is the local corporate bond market where yield-hungry investors have been happily snapping up one fresh issue after another.

What is of interest, as I had noted in my recent Cai Jin column, is the strong revival in interest in a certain bond-like instrument known as perpetuals, or perps, for short.

The attractive feature about a perp is that it comes with an attractive coupon payout - easily the highest payout which an investor can get in the market. Currently, coupons for perps are in the range of 4 per cent or more.

But the catch is that the issuer has the discretion to withdraw the coupon payment without triggering a default on his other outstanding loans. (In other words, it won't go bankrupt if it decides not to make interest payment on the perps and there is no recourse for investors to get it to pay up.)

The issuer also reserves the right to repay the principal to the perp investor, and in this context, the perp may literally mean a loan in perpetuity.

The other feature about perps is that companies will only issue them to lock up the funds needed to run their business, despite the high interest costs, when liquidity is tightening - like now when the US central bank is beating the drum on the likelihood of further interest rates hikes ahead.

Now, considering all the reservations raised about perps, I would have thought that investors should tread it with care. But if there is one market where exuberance has reached fever-pitch, it is the perp issuance market here.

Earlier this week, there was a report that UK insurer Prudential plc had received orders of over US$12 billion when it launched its perp issue of US$1 billion here.

The huge interest which Prudential drew to its perp issue simply highlights the large sums of money sitting idle in the local banking system looking for a better venue for investment.

This is considering the big sums already spent by investors who snapped up other recent perp issues launched by the likes of United Overseas Bank, Mapletree Logistics Trust and Societe Generale.

But the fact that perps are drawing investors in big numbers has made some market pundits worried.

It is also perplexing to find foreign issuers jostling with local companies for funds in the local perp market.

After I made a case for the need to have bonds rated in a separate column recently, I got an email from former investment banker Ng Lak Chuan expressing surprise that I did not examine the Hyflux perp issue in more detail in my write-up.

While other perp issuers had confined their offerings to the wholesale market, whose target audience were fund managers, pension funds and wealthy individuals, Hyflux had gone one step further and opened up its perp offering to retail investors.

While it had initially wanted to raise only $300 million from its perp issue, it managed to upsize its offering to $500 million, after getting an overwhelming response from the investing public.

But Mr Ng was concerned that issues such as Hyflux's declining profitability and the high leverage on its balance sheet had not been given a proper airing.

I also have concerns of a more general nature where the bond market is concerned.

When interest rates go up, bond prices go down because investors demand a higher yield in order to continue holding the bonds.

For bond investors, the biggest worry is the threat of rates hikes that may come from the United States and the collateral damage it may inflict on the debt market here.

That is because any US interest rate hike may cause international investors to pull their money out of regional markets.

To stop the funds from draining out of the region, and to address this problem, interest rates will have to jack up in order to lure them to continue to keep their money here.

Therein lies the problem.

The US Fed can afford to raise interest rates in what it describes as a "normalisation" exercise - after depressing it for many years after the 2008 global financial crisis - because the US economy is humming along just fine with unemployment falling back to its pre-crisis low of 5 per cent.

But Asean countries can ill-afford to do likewise and jack up interest rates because their economies have turned sluggish. If anything, they have to loosen their monetary policies in a big way and cut interest rates aggressively to stir up demand.

But the threat of capital outflow by international investors destabilising their economies may leave them no choice at all.

Asian bond markets had a foretaste of this massive outflow of foreign capital in late 2013 during the "taper tantrum" drama, when then Fed chairman Ben Bernanke first hinted at scaling back the then massive sums which the US central bank had been pouring into the financial market each month as part of its efforts to revive the US economy.

Maybe, it is with this episode in mind that many companies are issuing perps to ensure that they are not caught short of capital just when it is needed most just in case there is a credit crunch.

Of course, they may just be playing it safe. But there is no harm in making hay while the sun shines.

* Goh Eng Yeow will be hosting DBS chief executive Piyush Gupta to a chat on investments at the Singapore Coffee Festival on Saturday, June 11, at 4 pm. Venue: F1 Pit Building