[The Editors' Verdict] The Heungkuk Life Incident and the Perpetual Bond Controversy

The ‘Heungkuk Life Incident’ seems to be settling down as the company decided to redeem its perpetual bonds (hybrid capital securities) early. However, it is necessary to clarify the facts of the incident and reassess the controversies surrounding perpetual bonds raised by this case.

Perpetual bonds are hybrid securities that combine characteristics of both bonds and equity. Although they have a maturity of 30 years, the maturity can be extended further, which is why they are called perpetual bonds. Usually, after five years from issuance, the issuer can exercise a call option to redeem the principal and interest early. If early redemption is not advantageous, the issuer can choose not to exercise the call option and bear a penalty interest rate (interest step-up). The issuer can also defer interest payments, accumulating unpaid interest to be paid in a lump sum later. All choices regarding principal and interest repayment lie with the issuer, not the investor.

Because the issuer can choose whether to redeem, perpetual bonds are recognized as equity in accounting. This is due to the much lower redemption obligation compared to bonds. Being accounted as equity, they are used to improve various financial ratios involving capital. They help improve the BIS ratio of financial holding companies and banks, the RBC ratio of insurance companies, the leverage ratio of credit finance companies, and the debt ratio of corporations.

Applying this to the Heungkuk Life case: the perpetual bonds issued by Heungkuk Life in 2017 carry an interest rate of 4.475% per annum. If the call option is not exercised this year and the step-up applies, the company must bear an interest rate of 6.7% per annum. If the perpetual bonds are redeemed early and reissued in the market, the interest rate would approach 10% per annum. Given this situation, it is a rational choice for Heungkuk Life to pay 6.7% interest.

Exercising the call option is preferable to reissuing perpetual bonds at a high interest rate, as it reduces interest burden and helps maintain the RBC ratio. Is it justifiable to dismiss this economically practical choice as a matter similar to the Legoland incident and blame it as a cause of credit tightening? If the Legoland incident involved failure to fulfill obligations, the Heungkuk Life case involves exercising rights, marking a significant difference between the two. In fact, Heungkuk Life can be seen as a victim of the market interest rate rise caused by the Legoland incident.

There is also a flaw in the claim that exercising the call option is customary. Perpetual bonds have been continuously issued in a low-interest environment. For issuers, it has been advantageous over the past decade to reissue perpetual bonds at a lower interest rate rather than exercising the call option and paying penalty interest exceeding 1-2%. At that time, exercising the call option was an economically sound choice for most issuers in terms of interest burden. Is it right to pressure companies so they cannot make economic choices by framing call option exercise as a customary practice?

An official from a global investment bank (IB) hinted, "Perpetual bond investors generally hedge interest rate and currency fluctuations only until the issuer’s call option exercise date." This means that if early redemption is not received, investors face significant losses due to rising market interest rates. Could it be that the obstinacy of investors fearing non-redemption of perpetual bonds is the real issue? The price drop (interest rate rise) of Heungkuk Life’s perpetual bonds was likely caused by panic selling from investors who did not anticipate the call option would not be exercised.

It is worth examining whether exercising legitimate rights is wrong or if it is the fault of investors who failed to anticipate that companies would not redeem perpetual bonds early even amid a sharp rise in market interest rates. During the issuance of perpetual bonds, the issuer may have requested a lower interest rate in exchange for early redemption. However, a verbal agreement or implicit custom of early redemption cannot take precedence over the legal contract between issuer and investor.

Every year, the call option exercise period for perpetual bonds worth trillions of won arrives. Yet, do domestic financial companies and corporations have to exercise call options under market pressure every time, even if it is disadvantageous to themselves, simply because of contractual rights? If the redemption obligation is this strong, is it not problematic to recognize perpetual bonds as equity in accounting?

Lim Jeong-su, Head of Capital Markets Department

This content was produced with the assistance of AI translation services.