The term "perpetual bonds" referred to in this article means bonds with no explicit maturity date or with an extremely long term, theoretically existing indefinitely. Perpetual bonds are characterized by features such as issuer call options, high coupon rates, subordination clauses, and step-up or reset mechanisms for the coupon rate. Currently, perpetual bonds in China are mainly distributed across several categories, including medium-term notes, corporate bonds, and enterprise bonds.

From the perspective of the issuer (financier), perpetual bonds offer advantages such as reducing the debt ratio and the possibility of extension under certain conditions. For investors, the high coupon is also very attractive.

I. Main Features of Perpetual Bonds

(1) Extension Option

Generally, perpetual bonds include a clause stating that the bonds "exist for a long term before the issuer redeems them according to the terms of the issue, and mature when the issuer redeems them according to the terms of the issue." This clause is also an important basis for perpetual bonds to be included in equity. However, "long-term existence" does not align with the preferences of most fixed-income investors. Therefore, an option day is set at an agreed cycle (usually starting from the end of the third year), on which the issuer has the right to redeem the bonds from the holders unconditionally at par value plus any accrued interest. Most investors hope that the issuer will exercise the redemption right. So, how do investors judge whether the issuer will exercise the right for a particular bond? This involves the next special clause of perpetual bonds.

Advertisement

(2) Interest Rate Step-up Mechanism

To constrain the issuer to exercise the right on time and to give investors the expectation that the issuer will exercise the right promptly, most perpetual bonds typically have an interest rate step-up mechanism in their issuance terms. That is, if the issuer chooses to extend (not exercise the right) on the option day, to compensate investors, the subsequent bond coupon rate will be increased by a certain level based on the original interest rate pricing standard, mostly by a step-up of 300 basis points, or 3%, which is a relatively high increase. It has the nature of a punitive clause.

Of course, nothing is absolute, and some perpetual bonds may stipulate that the interest rate does not step up over a longer interest period. For example, a perpetual bond issued by a certain state-owned enterprise stipulates that "if the issuer does not exercise the redemption right, the coupon rate during the 5th reset period (from the 13th to the 15th interest year) will be adjusted to the current benchmark rate plus the basic spread plus 300 basis points (1 basis point is 0.01%)." This means that the issuer can keep the bond in existence for 12 years without incurring any additional costs.

(3) Deferral of Interest Payments

Unless a mandatory interest payment event occurs, the issuer can defer its payable interest to the next interest payment date without any limit on the number of deferrals, and the deferral of interest is not considered a default by the issuer. Each deferred interest should be compounded at the current coupon rate during the deferral period.Mandatory interest payment events refer to: ① paying dividends to shareholders; ② reducing registered capital.

(IV) Order of Repayment

In the event of bankruptcy liquidation, the order of repayment for ordinary perpetual bonds is equivalent to all other repayable debt financing instruments (or liabilities) of the issuer, that is, it is on par with ordinary bonds in the bankruptcy repayment order and has priority over preferred shares and common shares.

The order of repayment for subordinated perpetual bonds in the event of bankruptcy liquidation is after the issuer's ordinary debts; they are on the same repayment order with other subordinated debts issued by the issuer and are on the same footing for repayment with any other subordinated debts that may be issued in the future.

II. Reasons for Issuing Perpetual Bonds

Since the implementation of supply-side structural reform in 2015, the term "deleveraging" to reduce the micro asset-liability ratio of enterprises has often been mentioned in central-level documents and announcements, with state-owned and central enterprises having an even more urgent requirement for "deleveraging." Against this backdrop, the advantages of perpetual bonds have become apparent:

(I) In accounting treatment, the issuer of perpetual bonds can record them in the "other equity instruments" account in the equity section. According to the requirements of the financial accounting document [2017] No. 14, combined with the specific contract terms of the perpetual bonds, the classification as equity instruments or financial liabilities is determined based on the principle that economic substance is more important than legal form. However, in practice, most issuers account for and describe perpetual bonds as equity instruments. Due to the characteristic of perpetual bonds being counted as equity, they can to some extent play a role in reducing leverage for state-owned and central enterprises with high debt ratios, aligning with the goal of bond-issuing entities to lower the asset-liability ratio. In recent years, perpetual bonds have seen rapid development.

(II) Although perpetual bonds are accounted for as equity, investors in perpetual bonds do not have voting rights, do not dilute company equity, and reduce governance disputes between old and new shareholders.

III. Logic for Investing in Perpetual Bonds

(I) High interest ratesThe coupon rate of perpetual bonds is higher than that of non-perpetual bonds of the same type. It can be understood as purchasing ordinary bonds while simultaneously selling a bond deferral option to the issuer, who will pay a certain cost for this option.

(II) The probability of deferral can be anticipated

An extension beyond market expectations would trigger a credit event, so issuers will not actively choose this option unless absolutely necessary. Because the adjusted coupon rate is much higher than the rate at the time of issuance, and the issuer still chooses to extend or defer interest, it is likely that the issuer is experiencing a financial crisis, usually accompanied by a downgrade in ratings and an interruption of new financing, which could potentially lead to bond default. At this time, if the order of liquidation is the same, the situation for perpetual and non-perpetual bonds is essentially the same.

For perpetual bonds without a rate step-up, the probability of deferral is relatively high, and their non-step-up period (such as 12 years) can be considered as their lifespan. It is only necessary to consider whether the bond rate is reasonable against this period, and even if there is a deferral, it is in line with expectations.

In summary, by using the step-up clause, one can reasonably anticipate the probability of deferral, and it is unlikely to bring risks due to spillover from the variety.

(III) Clear liquidation order agreement, with the option to choose independently

Perpetual bonds with a liquidation order equivalent to ordinary liabilities will be treated equally with non-perpetual bonds in the event of risk disposal such as bankruptcy reorganization.

IV. Key points in evaluating perpetual bonds

Undoubtedly, investing in perpetual bonds is to obtain the premium of the bond variety to achieve excess returns. The realization of excess returns is based on the premise of "results meeting expectations." To avoid pitfalls, on the basis of evaluating non-perpetual bonds, the following terms should be kept in mind.

(I) The presence of a rate step-up mechanism and whether the step-up margin is appropriate—subtext: whether the customer will exercise the option.For perpetual bonds, whether the investor exercises the option is the second major concern after credit risk events, and a reasonable assessment should be made before investing in bonds. If there is no interest rate step-up mechanism, or if the step-up is insufficient, the probability of bond extension will greatly increase. At the same time, the lower the step-up basis points, the lower the issuer's cost of extending the term, and thus the higher the likelihood of extension. To compensate for the uncertainty brought to investors by the extension, perpetual bonds with a lower step-up basis points have a relatively higher coupon rate.

For some bonds that do not experience a step-up in the coupon rate during the first few reset periods, such as "14 Capital Group Renewable Bond 01, 15 China Power Investment Renewable Bond, 14 Capital Group Renewable Bond 02, 15 Shanxi Coal MTN001, 15 Beidahuang MTN002," the benchmark interest rate during the reset period is not significantly different from, or even lower than, the benchmark interest rate at the time of issuance. Therefore, the adjusted coupon rate is not much different from, or is lower than, the coupon rate at the time of issuance. In this case, if the cost of choosing to extend is lower than the cost of issuing new bonds, the issuer may choose not to redeem the principal and interest of the bonds and opt for extension.

(II) Whether the order of liquidation meets expectations - Subtext: In the event of credit risk, it assumes more risk and default losses than ordinary bonds.

If the issuance terms stipulate that "the order of liquidation of perpetual bonds in the event of bankruptcy is the same as all other debt financing instruments and liabilities of the issuer," then in the event of insufficient solvency of the issuer, it will not bear more default losses than non-perpetual bonds.

If the order of liquidation of perpetual bonds in the event of bankruptcy is after the issuer's ordinary debts, it is necessary to assess the probability of default and evaluate whether the premium for the variety can cover the risk brought by the order of liquidation.

V. Operation of Perpetual Bonds

In terms of the types of bonds issued, medium-term notes are the main type, accounting for 76.54%.

In terms of the issuance term, 3+N and 5+N are the main ones. About 97% of the terms of perpetual bonds in our country are 3+N and 5+N, meeting the long-term capital needs of financing enterprises.

In terms of the nature of the enterprise, the issuers are mainly state-owned enterprises. Local state-owned enterprises and central enterprises account for more than 95%, which can play a role in reducing the leverage of state-owned enterprises with high debt ratios to a certain extent.

In terms of the main body rating, the issuers are mainly concentrated in the middle and high ratings of AAA and AA+, accounting for nearly 90%. Compared with other types of bonds, the issuers of perpetual bonds are relatively high-quality.In terms of industry distribution, the industries of the issuing entities are primarily concentrated in cyclical sectors such as construction, transportation, and manufacturing, which are characterized by heavy assets and high levels of debt.