The 9.50% Perpetual and the Property Deposit
Ms Lam, 55, is a HKD-based client with a HK$6.0 million portfolio held with your firm (60% in HKD deposits and investment-grade HKD bonds, 40% in a diversified equity fund). Her documented risk profile is 'medium', and she told you in March that she needs to release HK$1.5 million in about 18 months to complete a property purchase.
She has now asked you to buy USD 200,000 nominal of 'Prosper Well 9.50% Perpetual Subordinated Notes', issued by a mainland property developer. Key terms: no fixed maturity; callable from 2028; if not called, the coupon resets to the then-prevailing 5-year US Treasury yield plus 300bp; deeply subordinated; minimum denomination USD 200,000; S&P rating B+.
Your desk is quoting the notes as principal at 99.25, against a desk mid price of 98.15, with a 1.10% markup. Ms Lam has no USD income and has never bought a perpetual.
1. Explain to Ms Lam what it means that the firm is acting as principal, including how the price and markup should be handled.
Read the worked answer
Capacity. When the desk quotes 99.25 as principal it is selling from its own book: the firm is the counterparty, not the client's agent. Two consequences follow.
- Disclosure. The client should be told the firm is acting as principal, and the confirmation should show the capacity and the price. The firm must act fairly and transparently; where it charges a markup over the market price, the client is entitled to understand that cost.
- Conflict. The desk's quote reflects its inventory and its view of the market, and your remuneration may be linked to the markup. You cannot simply pass on the first quote.
The arithmetic. Mid is 98.15; the client pays 99.25. That is 1.10 points, about 1.12% of mid - on USD 200,000 nominal roughly USD 2,200 of embedded cost, before accrued interest. She should see that number, not just the yield.
Best execution. For an OTC bond there is no exchange order book, so best execution means taking reasonable care to obtain a fair price: check the price against another market maker or a pricing service, consider the size and liquidity, and document the comparison. If the desk's price is out of line, push back or source the bonds elsewhere.
Costs and settlement. Confirm accrued interest (the buyer pays the seller's accrued coupon), the settlement date (typically T+2 or T+3 for international bonds) and any custody fee. Note that Hong Kong stamp duty applies to transfers of Hong Kong stock, not to debt securities, so no stamp duty arises here.
2. Identify the features of this instrument that differ from an ordinary fixed-rate bond and explain why each matters to her.
Read the worked answer
- No maturity. A perpetual has no redemption date. The issuer decides whether to call; she cannot put the bond back. If she needs the money in 18 months, the only exit is selling in the secondary market at whatever price is bid.
- Call from 2028 and coupon reset. The issuer will call if it can refinance more cheaply, so the investor tends to lose the 9.50% exactly when rates have fallen. If rates have risen, the issuer keeps the bond and the coupon resets to 5-year US Treasury plus 300bp. This is negative convexity: the upside is capped, the downside is not.
- Subordination. The notes rank behind senior obligations. In a restructuring - and mainland property has seen several - recovery can be low and the process slow. A B+ rating is below investment grade.
- Coupon deferral. Check the terms: many perpetuals permit deferral on a cumulative or non-cumulative basis, often with a dividend stopper. A missed coupon is not necessarily an event of default.
- Liquidity. A USD 200,000 minimum lot in a B+ perpetual trades in a thin market with a wide bid-offer. The 99.25 quote is a sale price, not a saleable price.
- Currency. She is HKD-based with no USD income. The peg limits day-to-day FX risk but not the cost of converting at the wrong time, and her liability (the flat) is in HKD.
- Interest rate risk. A perpetual's duration is high and hard to measure; the price will move more than a 2028 bond for a given change in yields.
3. Advise on suitability and explain how you would document your conclusion.
Read the worked answer
Test it against her stated need.
- Size: USD 200,000 is roughly HK$1.56m, about 26% of a HK$6.0m portfolio, on top of a 40% equity fund position. A single B+ issuer would be about a quarter of her assets.
- Horizon: she told you in March she needs HK$1.5m in about 18 months. This instrument has no maturity and no reliable exit, so funding a property completion from a perpetual is a liquidity mismatch. If she has to sell in a stressed market she may realise well below 99.25.
- Risk profile: 'medium' does not encompass a sub-investment-grade subordinated perpetual with coupon deferral features.
- Yield: 9.50% is compensation for credit, subordination, call and illiquidity risk, not a free lunch.
Conclusion: unsuitable as the home for her property money. Alternatives: a senior, fixed-maturity bond maturing before the completion date; a short-duration or investment-grade fund; or a much smaller perpetual position funded from capital she will not need for at least five years.
Documentation: explain the features above in writing, record the recommendation and her response, and keep the pricing comparison you made. If she still wants to proceed, whether the firm accepts is a supervised decision, not yours alone. Note that a signed risk disclosure does not make an unsuitable recommendation suitable - paragraph 5.2 is about the recommendation, not the paperwork.