Tuesday, May 15, 2012

Rush into perpetual bonds cause alarm

The MAS is alarmed at the rush into investing in perpetual bonds. They are worried that the investors may not be aware about the risk of investing in these bonds that have no maturity dates. See this report.
http://www.todayonline.com/Business/EDC120515-0000049/Perpetual-bond-rush-causes-alarm-in-Spore

There is no need for MAS to be concerned. The investors are not that naive. They do know that these bonds do not have a maturity date. When they invest in shares, there is no maturity date either. Investing in perpetual bonds is similar to investing in shares, except that the perpetual bonds have a fixed coupon rate, while dividends on shares are not guaranteed and depend on the future profits of the company.

Both face the risk of insolvency of the company, but bond holders face a lower risk compared to shareholders, as they get paid earlier out of the proceeds of an insolvent company.

As many people understand the risk of investing in shares, the risk is much lower when investing in the perpetual bonds issued by the same company.

Perpetual bonds are quite straight forward, unlike the credit-linked securities, such as Mini-Bonds, Pinnacle Notes and other financial products that are based on derivatives  They are many complex financial products that MAS should banned from being sold to retail investors, but perpetual bonds are not within this category.

Investors should, however, be aware that all bonds, whether perpetual or non-perpetual, have a credit risk, i.e. there is the risk that the issuing company may become insolvent and be unable to pay its obligations. Investors should look at the credit rating of the bonds and, if the bonds are not rated, at the credit rating of the issuing company. If both the bond and the issuing company are poorly rated or unrated, the investors should avoid making the investment.

There is also the risk that interest rate will increase and will cause the value of the perpetual bonds to drop. If the long term interest rate increases by 1%, the market price of the perpetual bonds may drop by 20%. This risk affects all types of long term investments, and not just perpetual bonds.

This may not be of concern to the investor, if they are satisfied with the current yield (which is around 5%) and the inflation remains below this level, and they are investing for the long term.




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