A typical bond has a fixed tenure of maturity, but perpetual bonds, as the name suggests, can theoretically go on for as long as the issuer is a going concern.
Market regulator Securities and Exchange Board of India’s (Sebi’s) new rules around mutual fund (MF) investments in perpetual bonds have kicked up a storm. But what are perpetual bonds, who issues them and why are MFs an important part of the ecosystem? Let’s find out.
What are perpetual bonds?
A typical bond has a fixed tenure of maturity, but perpetual bonds, as the name suggests, can theoretically go on for as long as the issuer is a going concern. In practice, though, these bonds have a “call” option, which enables the issuer to redeem the bond at pre-fixed intervals. The call may not get exercised if the issuer sees market interest rates to be higher than the coupon of the perpetual bond. An investor in a perpetual instrument can get his principal back by selling the bond in the secondary market, or when the issuer decides to redeem the bonds.
Are these bonds risky? If so, why?
In India, banks issue perpetual bonds to meet their capital requirements under the Basel III norms (globally followed accounting norms that require banks to maintain a certain capital base at all times to withstand financial shock). Lenders could issue these bonds to raise Additional Tier 1 (AT1) capital, which acts as a component of core equity for a bank. The main element of risk stems from the fact that the issuer of these bonds has an obligation only to pay interest and is not required to repay the debt. Since the AT1 bonds are subordinate to debt instruments and only senior to
common equity, these are considered quasi-equity for banks.
Therefore, the risks associated are higher than with debt but marginally lower than equity. If its capital situation deteriorates, the bank can skip paying interest on these bonds. In case of a loss, the bank is not allowed to dip into past reserves to pay interest towards these bonds. Last year, as part of a package to rescue Yes Bank, AT1 bonds worth over Rs 8,000 crore were written off even before equity. This was when these bonds shot into the limelight.
Why would someone invest in these bonds?
As these bonds are riskier than other debt instruments, the issuer has to pay a higher interest/coupon rate. Typically, the spread between AT1 bonds and normal debt issued by the same issuer is at least 50-75 basis points higher. The higher interest rates make investing in these bonds attractive for an investor with a high-risk appetite. Investing in such debt instruments is also an attractive proposition for mutual fund debt schemes that aim to generate higher returns.
Why are perpetual bonds in the news again?
On March 10, SEBI issued a circular capping MF exposure to such bonds. Under the new rules, no fund house can under all its schemes hold more than 10 per cent of overall perpetual bonds issued by a single issuer. At an individual scheme level, exposure to single issuer of such bonds cannot exceed 5 per cent of the total corpus and overall exposure to such bonds is capped at 10 per cent of the scheme corpus. The regulator said the maturity date for such bonds should be considered 100 years.