I explain two significant risks of investing in perpetual notes issued by corporates:

1) Risk of default
b) Risk of increase in interest rate

I illustrate it with a perpetual note issued by Ascott Residential Trust

Type of security: perpetual fixed rate note
Coupon: 3.88%
Call date: 4 Sept 2024
 

Coupon	Yield	Price
3.88	3.86	100.6%
3.88	4.36	89.1%
3.88	4.86	79.9%

The current price of the perpetual note is 100.6. This implies that the investor expects a yield of 3.86% (i.e. 3.88/100.6).

If interest rate goes up by 0.5% (i.e from 3.86% to 4.36%), the price of the perpetual note will fall to 89.1. This will produce a loss of 11.5% for the investor.

If interest rate goes up by 1.0% (i.e from 3.86% to 4.86%), the price of the perpetual note  will fall to 79.1. This will produce a loss of 21.5% for the investor.

If interest rate falls, the issuer will redeem the perpetual note at par and reissue a new note at a lower interest rate.

This perpetual note offers a yield of 3.86%. A 30 year government bond offers a yield of 1.96%. The difference of 1.9% (i.e. 3.86-1.96) is to compensate the investor for the default risk and for the risk of an increase in interest rate.

As interest rate is now at a low level, there is the risk of an increase in interest rate. This will result in a severe fall in the price of the perpetual note. The issuer is not likely to call the bond.

Note - this is a personal view. I am not giving investment advice.

Tan Kin Lian