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Asia perp debacle should serve as a wake-up call

Perpetual Bonds-adobe-2022

Korean life insurer’s flip-flop on a bond call option will have lasting consequences and shows the shortfalls in the region’s debt market

Who doesn’t love a good Korean drama? While numerous Korean TV shows have taken the world by storm in recent years, the country hasn’t quite gripped the financial markets in much of a frenzy, rather being considered stable, strong and resilient.

That all changed in the past week.

On November 1, Heungkuk Life Insurance said it would not call back a $500m 4.475% perpetual bond on the first call date on November 9, citing unstable funding conditions in Korea and internationally. The move came just days after the insurer had sent notices to bondholders — but didn’t officially disclose to the stock exchange — informing them of its intention to redeem the notes.

The market reaction to the U-turn was extreme. Heungkuk’s perps tumbled over 30 points within days, with questions raised around systemic risks in the Korean market.

The impact wasn’t restricted just to Korean perps. Spreads on Korean senior bonds also widened dramatically — with the domino effect spreading to perps of Hong Kong banks and insurers. Perpetuals from even marquee issuers such as AIA Group were not spared, falling from high 80s to low 60s, before settling in mid-70s, within days.

Then came another pivot from Heungkuk. It backtracked again on Tuesday, saying that it will, after all, redeem the bonds at par. It pointed to “unnecessary concerns” about its solvency position and “shrinkage of investment sentiment in the Korean market” as drivers for the reversal.

The decision bought some relief to the market: Heungkuk’s perps saw a 25-point rally after the announcement.

But the flip-flop over whether to call or not to call should raise some serious questions about the development of the region’s debt market — whether firms are being forced to make uneconomical decisions around their debt portfolios due to investor pressure, and how investors are pricing non-call risks on perps.

Bowing to pressure

Unlike in the US or Europe, where borrowers skipping call options are not frowned upon, it’s a different story in Asia.

Here, issuers mostly carry big reputational risk for not calling bonds at the first call date. This can lead to restricted access to the debt market for future fundraising, as well as demand for juicier premiums. All this despite the bond terms stating explicitly that issuers are not obliged to call their deals on the first call date.

But this premise should wield less power at a time when rates volatility has sapped the life out of the debt market.

Asian borrowers have effectively written off the rest of 2022 when it comes to selling bonds and are instead planning their 2023 funding needs. A combination of high interest rates and global volatility has all but brought the bond market to a halt in recent weeks.

It’s true that investors tend to value perps on a yield-to-call basis, with expectations of the first call date as the maturity of the bonds. Many perps have calls every six months, although Asia has also seen aggressive fixed-for-life perpetual bonds too.

So where does the market go from here? It’s perhaps time to review premiums on these securities so that investors are adequately compensated for call risks.

It’s also time to be pragmatic and embrace these bonds with their risks — especially when the economic costs of calling back a note simply don’t make sense to borrowers.

Issuers should prioritise their own cost of funding rather than bowing to market pressure.

This applies more to financial institutions where perpetuals are often part of the loss-absorbing capital structure. For instance, Heungkuk had a solvency ratio of 158% in the first half of 2022 compared with the regulatory requirement of 150%. This means it did not have an option to call the perps without replacing them but at higher cost levels.

Moreover, regulators such as the Australian Prudential Regulatory Authority have urged their banks and insurers not to make “uneconomic calls”. In this context, market reaction to perpetuals seems unjustified.

In the end, Heungkuk turned to local institutions and its parent to bridge the gap. But such help is not available to every issuer. Several firms, including Hong Kong’s Chiyu Bank, have succumbed to market pressure and redeemed their bonds, despite funding conditions being far from suitable.

Others have held their own. For example, Mapletree Treasury said this week that it will not redeem its Singapore dollar denominated 3.95% perp at the first call date of November 12, citing tough market conditions. Another peer, ESR-Logos Reit, also decided against calling its 4.6% perp on November 3. These Singapore dollar bonds more or less remained stable in the secondary market.

In Korea, Woori Bank had failed to exercise the call on its $400m lower tier two bonds in February 2009, but it managed to issue new notes in June the same year and exercised the call option on the next call date.

More risks?

Of course, each perp issuer is assessed differently for its credit risk. But the Heungkuk saga sheds light on more trouble potentially looming for Korea’s, and Asia’s, debt markets if expectations of investors and issuers are not aligned.

Heungkuk’s flip-flop on the call option came amid weak market conditions in the country. Sentiment had started weakening from the end of September when an asset-backed security guaranteed by the Gangwon province for a developer involved in building a Legoland theme park missed an onshore coupon repayment of KRW205bn ($144m).

Even though the province said it would pay the missed payment by December 15, the damage was done.

Onshore money market yields started falling, with the yield on the 91-day commercial paper rising to above 4% for the first time since the global financial crisis. The spread between the CP yield and the Bank of Korea policy rate rose above 150bp — the widest level since the financial crisis. Korean credit default swaps jumped over 70bp.

Amid the mayhem, calming investor sentiment by reversing tack on Heungkuk’s call option makes sense. But it has also left many other perp issuers between a rock and a hard place.

Issuers, investors and DCM houses should use this opportunity to reassess the way they sell perps and the way they are priced — looking at both the yield-to-call and the yield-to-maturity.

It helps that Asian banks, in general, are considered to be well capitalised, meaning they can afford to call back bonds without prefinancing it. But if nothing else, the Heungkuk incident should serve as a much-needed wake-up call to the market.