The Perpetual Bond Dilemma

All You Need to Know About Perpetual Bond

Introduction

In the second week of March 2021, market regulator SEBI issued a circular reviewing the norms regarding investment in debt instruments with special features and in particular the valuation of perpetual bond. It swiftly caused a stir among mutual funds and prompted the Ministry of Finance step in.

To quote Steve Jobs – “You can’t connect the dots looking forward; you can only connect them looking backwards.”

In today’s blog, we connect the dots looking backwards and decipher the Perpetual Bond Dilemma.

The Perpetual Bond Dilemma

Let’s start with some basics.

What is Perpetual Bond?

A bond is a debt security in which an investor loans money to an entity (typically corporate or government) for a defined period of time say 5 years. The borrowing entity pays a fixed or variable interest rate to the investors every year and eventually returns the original loan amount at maturity i.e. at the end of 5 years. The capital raised through these bonds is used to finance a variety of projects and activities.

There are different types of bonds that can be issued to suit the diverse needs of the borrower. There exists a rather peculiar kind called Perpetual Bonds.  A perpetual bond is a bond with no specified maturity date. These bonds do not repay the original loan amount; instead they only pay a steady stream of high interest rate to the investors forever. Yes, you read it correctly – Forever.

Perpetual bonds empower companies to smoothly raise the capital required to fund their ambitious expansion plans without significantly adding to their exist debt liabilities and diluting equity.

Fun Fact – In 2013, Reliance Industries raised Rs 4,300 crore through perpetual bonds at an interest rate of 5.875% from investors abroad to fund its Rs 1 Lakh Crore capex plan to expand petrochemicals business and ramp up oil & gas exploration.

Now that you’re all caught up, let’s dive into the crux of the matter.

Deep Dive into AT-1 Bonds

The protagonist of this episode is Additional Tier-1 Bonds (AT-1 Bonds).

During the Global Financial Crisis (2007-2008), several marquee global banks like Lehman Brothers and Merrill Lynch went bust and many others were on the brink of bankruptcy. As a consequence, Basel III an internationally agreed set of measures were developed by the Basel Committee on banking supervision. These measures aimed to strengthen the regulation, supervision and risk management of banks.

A crucial measure the Basel III initiated was that it imposed the banks to increase the capital on their balance sheet by issuing Additional Tier-1 (AT-1) and Additional Tier-2 (AT-2) Bonds. The capital raised through these bonds will enhance the bank’s capability to absorb the financial repercussions of any unanticipated events emerging from financial or economic instability. They’ll help minimize insolvency risk for the bank.

AT-1 or Additional Tier-1 Bonds are perpetual bonds issued by banks in compliance with the Basel III regulations. They are a component of the bank’s permanent equity and furnish relatively high interest rates, posing as lucrative investment options for big players like mutual funds, pension funds, etc.

A famous saying by Gerry Schwartz springs to mind –  

“There is no such thing as high returns without risk.”

Let’s put light on the risks underlying these high return AT-1 Bonds.

AT-1 Bonds

If a bank is recording losses in a given year and their Common Equity Tier 1 ratio slips below 8%, the bank can either fully or partially skip interest payment to AT-1 bondholders.

If a bank reaches the brink of bankruptcy and their Common Equity Tier 1 ratio slips below 6.125%, the entire principal value of AT-1 bonds can be written off or simply converted into common equity. Therefore, investors can lose all their money in the blink of an eye.

AT-1 Bonds have no maturity. But to captivate investors, they are issued with call options. It means that if a bank has sufficient capital, it can call back the bonds and repay the investors. Call options are usually offered at the end of 5 or 10 years. These call options are voluntary and the banks may or may not choose to exercise them. Almost all Indian banks have exercised these call options and redeemed their respective AT-1 Bonds.

In March 2020, the chickens had come home to roost for the infamous Yes Bank. The RBI decided to wipe off Yes Bank’s Additional Tier-1 bonds worth Rs 8,415 crore. As a consequence, several mutual funds debt schemes and pension funds lost thousands of crores. Ultimately, the unit holders of these debt schemes bore the brunt.

SEBI Caps Mutual Funds’ Exposure to Perpetual Bonds

With a view to safeguard retail investors from a similar mishap in the future, SEBI in the second week of March 2021 issued a circular reviewing the norms regarding instruments like AT-1 and AT-2 Bonds. These new norms would be applicable from 1^st April, 2021.

The new stricter norms are as follows –

1. No Mutual Fund under all its schemes shall own more than 10% of such instruments issued by a single issuer.
2. A Mutual Fund scheme shall not invest –

a. more than 10% of its NAV of the debt portfolio of the scheme in such instruments; and

b. more than 5% of its NAV of the debt portfolio of the scheme in such instruments issued by a single issuer.

• Further, the maturity of all perpetual bonds shall be treated as 100 years from the date of issuance of the bond for the purpose of valuation.

The last norm about treating the maturity of AT1 bonds as 100 years caused a stir, putting the mutual funds in a state of flux. Let’s understand why.

According to the Ministry of Finance, the overall market for AT-1 bonds is Rs.90,000 crore of which Rs. 35,000 crore are held by mutual funds. As per Crisil, as on 31st January 2021, 36 MF schemes hold more than 10% exposure to AT-1 and Tier 2 bonds.

An article from Mint accurately states that –

“AT-1 or perpetual bonds are traditionally valued at price-to-call. This means that mutual funds have valued them as if they would be repaid on the call dates. Such dates are typically set at short intervals of, say, 5 to 10 years, and hence their maturity is set accordingly.”

Keep in mind – the longer the maturity of an instrument, the higher the interest rate risk because the time taken for investors to receive the full payment increases. Hence, an abrupt change in the maturity assumption of these AT-1 bonds from the earlier 5 or 10 years to 100 years will escalate the interest rate sensitivity (i.e. duration) of these bonds dramatically, making these bonds all the more riskier. 

As an article from Moneycontrol notes –

“With the tenure fixed at 100 years, and with no benchmark to mark these bonds against, the MTM (mark to market) losses on these instruments will be high and the abrupt drop in valuations will lead to large NAV swings as MFs will rush to sell these bonds fearing large redemptions.”

If implemented, this norm could wreak panic in the debt markets and have detrimental ripple effects like –

• Rapid redemptions by unit holders could shrink mutual fund’s appetite for AT-1 bonds and eventually lead to increased borrowing costs for banks.
• Smaller banks with weak financials will find it difficult to raise capital via AT-1 bonds. This could especially prove hazardous for PSU banks, as it will further pressurize the Government to take the onus and inject more equity.

To avoid the above mentioned consequences from turning into reality. The Ministry of Finance, Association of Mutual Funds India (AMFI) along with various Mutual Funds requested SEBI to withdraw the 100 year maturity rule.

And so, SEBI issued a clarification on the valuation of bonds issued under Basel III framework.

Now, the remaining maturity of Basel III Additional Tier-1 (AT-1) bonds will be 10 years until 31 March, 2022. This 10 year period will extend to 20 years and 30 years over the subsequent six-month periods. From April 2023 onwards, the residual maturity of AT-1 bonds will become 100 years from the date of issuance of the bond.

Further, if the issuing bank does not exercise the call option on these AT-1 bonds due to financial stress, adverse news or any other reason. Then valuation shall be done considering a maturity of 100 years from the date of issuance for AT-1 Bonds.

There you have it, the entire story from start to finish.

We hope you enjoyed reading it as much as we enjoyed writing it.

Have a great weekend ahead.

Wishing you a very Happy Holi in advance from all of us at Yadnya Investment Academy.