Good stocks to invest – Perpetual Securities – What you need to know as Stock Investors



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Ah the attractive perpetual securities.

We seem to notice companies issuing them in groups. It is as if they discussed with each other what is the best way to raise capital in the current operating climate and come to a conclusion raising perpetuals are the best way to go.

As an investor, you may look at perpetual securities as #1 your wealth machine focusing on manageable returns with lower volatility from bonds, preference shares, insurance endowment and perpetuals and #2 from your perspective as an active stock investor, how these perpetuals will affect your stock investments.

Today, we try to bring the discussion to #2 and I will not cover how you should evaluate these perpetual as an investor looking for manageable returns by not pushing volatility hard.


The companies issuing perpetual securities

Mapletree Logistics Trust (7.1% Dividend Yield not factoring capital distributions) will be issuing $250 million of perpetuals priced at 4.18%. This is 2.3% higher than current 5 year swap offer rate (SOR) of 1.88%. The minimum size is $250,000.

Frasers Hospitality Trust (6.2% Dividend Yield) will be issuing $100 million of perpetual securities at 4.45%. This will be use to purchase a 58.4 million Euro hotel in Dresden, Germany.

Hyflux, will be issuing $300 million in perpetual securities with an option to up-size the issue to $500 million in the event of over-subscription. The bulk is targeted at retail investors who can subscribe with as little as $2000.  The perpetual is priced at 6%.

United Overseas Bank (UOB) will be issuing $750 million in perpetual securities priced at 4%.

The different forms of Capital Raising

Before we go on with this discussion, here is a summary of different ways businesses can raise capital:

  1. Equity or stock issue to get your money so that you become a shareholder (IPO and Rights Issue/Cash Call)
  2. Equity or stock issue to other investors, usually institution investors (Placements)
  3. Preference shares, which are more senior to normal shares, that the company must declare a dividend, if they issue dividend to normal shares. This does not mean they will always pay a dividend. In the case of perpetual securities, they are preference shares but with no maturity date.
  4. Bonds, Debts, Medium Term Notes, Bridging loans are loans from financial intuitions for a fixed maturity date for a fixed return. In some cases bonds can be perpetual as well.
  5. Convertible bonds. Same as #4 but they usually have a target price where they can be converted to equity or stocks
  6. Convertible Preference shares. Same as #3 but have the characteristics of #5 where they can be converted to normal stock

When we look at a business Balance Sheet, it is made up of Assets, Liabilities and Equities. Equities and Liabilities are the way business raised capital to keep the business going on.

Assets = Liabilities + Equities

Net Asset Value = Assets – Liabilities

Where they are found on a balance sheet

The various forms of capital raising belongs to:

Equity

  • IPO and Rights Issue
  • Placement
  • Preference Shares
  • Convertible Preference Shares

Liabilities

  • Bonds, Debts, Medium Term Notes, Bridging Loans
  • Convertible Bonds

Hierarchy of Cost of Capital and Rate of Return

In terms of cost of capital (if you look from the perspective that you are a business owner) and pure returns (if you look from the perspective that you are a wealth builder buying assets), the ranking is as follows, with the top highest cost and return:

  1. IPO, Rights Issue, Placement
  2. Perpetual Preference Shares
  3. Preference Shares
  4. Convertible Preference Shares
  5. Perpetual Bonds
  6. Long Term Duration Bonds
  7. Medium Term Duration Bonds
  8. Convertible Bonds
  9. Short Term Duration Bonds

Hierarchy of Volatility of these Instruments

Various forms of capital raising, held by you the wealth builder, are subjected to different volatility (top traditionally most volatile in my opinion):

  1. IPO, Rights Issue, Placement
  2. Perpetual Preference Shares
  3. Preference Shares
  4. Convertible Preference Shares
  5. Perpetual Bonds
  6. Long Term Duration Bonds
  7. Medium Term Duration Bonds
  8. Convertible Bonds
  9. Short Term Duration Bonds

Volatility is different from Risk, which is usually described as a permanent impairment of capital. (To understand more the difference, read my mammoth article on Risk and Volatility)

Business is finding different ways to raise capital for different purposes

The first thing to understand is that companies are always hungry for capital for different purposes.

The different purposes could be:

  1. Make accretive acquisitions (usually a good thing)
  2. Shore up balance sheets after some business mistakes (not usually a good thing)
  3. Corporate and working capital (neutral on this)
  4. A mixture of all the above

Their evaluation critieras

How they go about raising capital depends very much on the current economic climate and their current business configuration.

Each way of raising capital have good points but also shortfalls.  There is no holy grail.

All things equal, if you are a business manager, you  would try to sourced for the financing that is cheapest.

If you look at the hierarchy of cost of capital, the lowest would be short term bonds and the highest would be stocks, which have a greatest potential return, not to mention as a business owner, you are letting people share a percentage of your profits.

Balancing between liabilities and equity

However, things are not so simple.

If you borrow 90% debts and have 10% equity, a financial intuition will be very skeptical about your company from the risk perspective. Specifically they will wonder about your company’s ability to return the debts.

Rating agency determines your company risk profile based on your business cash flow, the amount of existing debt you have, your business operating climate going forward and assign you a rating.

This determines your cost of debt as well.

All thing said, it is tough to borrow 90% debts.

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If we look at the 4 companies issuing perpetual securities, 3 of them have lots of debts. The fourth one, UOB is a bank that are risk managing their profile in a business climate that some of their loans might be non performing and to remain compliant to minimum capital adequacy ratios (CARs)

The 2 REITs have debt to equity of near 40%. While they are not near the maximum debt to equity ratio of 45% mandated by MAS, it would just take some devaluation of their assets in these uncertain business climate to bring their balance sheet closer to the 45%.

The above places a limit on using debt as financing.

High Equity Cost of Capital and Lack of Accretive Acquisition Target

The alternative to put the company balance sheet in a healthier position is to increase the equity base via placement, rights issue/cash call.

Doing so have a negative effect, which is it will dilute existing shareholders, causing their earnings per share, dividends per share to go down.

Stock price will likely head down if this happens.

So the management will do this only when they pair it with an acquisition that will be boost shareholders return in the future.

The problem for the 2 REIT is that, the current economic climate is challenging for businesses in general, and this tightens the amount of rent growth organically. Cost of debt for leverage heavy REITs is forecasted to go up and hence the share prices of these REITs have corrected in the past 6 months. Dividend Yield (for REIT Managers this is their cost of capital if they choose to do a rights issue) have therefore gone up.

From the current dividend yield of REITs (as can be seen from my Dividend Stock Tracker) it makes it challenging to acquire an accretive asset.

In a low yield environment, everyone is fighting for yielding assets such that net property income yields of property assets around the world have been compressed.

Low Potential NPI Assets and High Cost of Capital makes a feasible accretive acquisition difficult for the 2 REITs. In some other rights issue such as the Croesus one, they could still issue debt and equity to make the acquisition accretive. However, it is likely the manager do not wish to make an asset acquisition just for the sake of doing it.

For Hyflux and UOB, it is even more challenging to go this route as there are likely not so much acquisition target on the market.

Perpetuals Take Cash Flow away from Stock Investors

Perpetual securities can be seen as bonds that typically requires them to be paid like bonds. If your ordinary share investor wants their dividend, then perpetual securities will have to be paid first.

Wealth builders should note this and subtract the cash flow required to pay for perpetuals away from the cash flow available to pay dividends when prospecting a potential business.

They are sometimes necessary when your hands are tied.

Frasers Commercial Trust (7.6% Dividend Yield) made use of perpetual and convertible preference issues as a form of capital to restructure Frasers Commercial Trust after they taken over it from Allco  in the past.

The 30% Rule in Evaluating Whether Perpetual’s Hybrid Status is being abused

To me, perpetual securities are debts masquerading as stocks. It gives a business an excuse to say “we are in a healthy position”

Rating agency Moody considers only 50% of perpetual issues as equity.

This means that if X REIT issues $100 mil perpetual, they only consider 50% as equity.

They also set a limit to how much of these perpetuals that can exist in a company they rate to be deemed healthy.

This limit is 30% of their capital, or that amongst their total equity, they are recommended to have less than 30% of this as hybrid equity.

Currently, most of the firms issuing hybrid securities are within this range.

Some Relevant Articles

Capital raising is not something new and will be discussed again and again. As investors, you would need to have a good mental model how to evaluate these news as they present themselves in announcements.

Here are some articles I written on what we have  discussed today:

 Conclusion

Perpetual securities are just one instrument that is in a company’s arsenal to gain capital for their business.

They are not a scam, but as a stock investor, it is your opportunity to evaluate whether the management is raising funds the right way at the right time. You do also look back at these raising to see if they made the right decision or not.

It is likely the current economic climate, and the state of most of the firms balance sheets makes this form of capital raising the most viable option.

I ran a Dividend Stock Tracker that Updates Nightly the dividend yields and various metrics of the popular dividend stocks such as Blue Chip Stocks, REITs, Business Trusts and Telecom Stocks In Singapore. Start by bookmarking it and view it daily.
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