Essentially a three-year bond - except it is perpetual
Wah Sun Holdings is a Hong Kong private company whose treasury portfolio is worth HK$120 million. Its investment policy permits only senior, rated bonds, a minimum rating of BBB-, no single issuer above 10% of the portfolio, and 'no perpetual securities'. Its relationship manager, Ivan, has been soliciting a US dollar perpetual issued by a mainland property developer: 9.5% coupon, first call in three years, no maturity date, coupon resetting to the three-year US Treasury plus 600 basis points if not called, ranked subordinated, rated BB- and constituting 14.6% of the portfolio if bought at HK$15 million. Ivan's pitch email says: 'Essentially a three-year bond with a 9.5% yield - the issuer will certainly call.' The firm sells the bonds to Wah Sun as principal at 101.25 when the interdealer market is 99.50. Wah Sun has a current professional investor certificate and HK$120 million in the account.
1. Was Ivan's description of the instrument accurate? Identify the misdescription and the risks he failed to explain.
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The description was wrong in ways that matter.
- Perpetual means no maturity date. The issuer can call after three years; it is not obliged to. The investor's money can be at risk indefinitely.
- The '9.5% yield' is yield-to-call - a scenario in which the issuer exercises an option that happens to favour the investor. If the issuer does not call, the coupon resets to three-year US Treasuries plus 600bp. That looks like compensation, but a reset of that size is usually a signal of issuer stress, and the bond's market value may by then have fallen sharply.
- Subordination and credit. BB- is below investment grade. On a default, subordinated perpetual holders rank behind senior creditors and may recover very little.
- Liquidity. Perpetuals from stressed issuers can become effectively unsellable precisely when the investor wants out.
- Price. At 101.25 against a 99.50 interdealer level, the client starts roughly 175bp behind, which further reduces the actual yield.
A fair description would set out the call as the issuer's option, the reset mechanics, the subordination, the rating, the absence of a maturity date and the secondary-market risk, and would quote yield-to-call and yield-to-worst with the assumptions stated. 'The issuer will certainly call' is a prediction, not a term of the instrument.
2. Apply the suitability obligation. Should the firm have executed the trade, and does the client's professional investor status change the analysis?
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Paragraph 5.2 of the Code of Conduct requires a solicited recommendation to be reasonably suitable having regard to the client's financial situation, investment experience and investment objectives. It applies here because Ivan is soliciting. If the bond were a complex product, paragraph 5.1A would add a further layer; even treated as a plain bond, 5.2 governs a solicited sale.
The client's own investment policy is the clearest evidence of its objectives: senior rated bonds only, minimum BBB-, no more than 10% per issuer, no perpetuals. The trade breaches three of those four constraints and puts 14.6% of the portfolio into a single BB- subordinated perpetual. A treasury function with a written policy prohibiting perpetuals is not a suitable buyer for this instrument.
Professional investor status does not cure this. A HK$120 million portfolio and a current PI certificate affect documentation, disclosure and the availability of certain exemptions; they do not entitle the firm to sell a product that contradicts the client's stated policy. Corporate PI treatment is also only meaningful where the firm has actually put the paragraph 15.5 procedures in place - it is not a blanket opt-out.
Conclusion. The firm should not have recommended or executed. It should have told the client in writing that the trade conflicts with its own policy and escalated. If the client, fully informed, gives a genuinely unsolicited instruction, the firm must document that it made no recommendation and obtain senior sign-off - unlikely where the policy expressly prohibits the product.
3. The firm sold as principal at 101.25 against a 99.50 market. What should have been disclosed, and what are the consequences?
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Disclosure. The firm was acting as principal, not agent. It should have disclosed that before dealing, told the client the price included a mark-up over the interdealer market (about 175bp here), and explained the basis of its remuneration. When a firm sells from its own book, the client is entitled to know that its counterparty is the firm and that the firm earns from the spread.
Consequences. An undisclosed mark-up is a fair dealing and transparency breach, and the SFC has disciplined firms for this in fixed income. It also puts best execution in issue: the client may have been able to buy at or near 99.50 elsewhere, and the firm had no basis for giving itself the difference without telling the client.
Remediation. Reprice or compensate the client; review the principal trading and mark-up disclosure policy and the standard trade confirmation wording; and check whether the same template was used with other clients, which would widen the problem.
Combined exposure. The misdescription, the breach of the client's own policy and the hidden mark-up together make a mis-selling complaint likely to succeed. The firm should expect a client claim, an SFC inquiry and possible findings against both Ivan and the supervising desk. Defending the case on the basis that the client is a professional investor will not work: PI status does not waive fair dealing, and it does not make a perpetual bond into a three-year bond.