Perpetual Bonds: immortal, or is it?

They say, “Immortality is a fate worse than death!” And what could illustrate the mishap better than the ‘immortal’ Perpetual Bonds? Well, we bet you won’t wanna miss its little-known story.

Perpetual Bonds have been here for a while. But little did anyone care to talk about the (dangerous) elephant in the room. Not until the trumpet came out loud, a year ago in the Yes Bank fiasco. And since then, it’s been the talk of the town. The matter further gained momentum when very recently, these ‘immortal bonds’ became mortal following a regulatory change.

However, there is not much that people know about these (over-complicated) perpetual bonds. That’s the simple reason why banks and companies have been able to dupe investors. Well, read this article, and we assure.. you’ll make sense of what they won’t tell you.

At the outset, here’s a memoir on Perpetual Bonds, and as we always do, let’s begin with a story.

What are Perpetual Bonds?

Say you run a bank. Let’s keep it simple - you just accept deposits and lend money. And the interest spread is yours to keep. But the thing is, lending money is risky. In spite of maintaining provisions for bad loans, you never know when, unbeknownst to you, a good borrower will default, and your good loans will turn bad. And such unexpected losses could halt your lending business. That’s why it’s prudent to keep a certain amount of money with you to stave off any such unexpected crisis. Like if you lend Rs 100, you keep Rs 10 as capital with you. This is the Tier 1 Capital.

So, this Tier 1 Capital comprises equity shares issued by your bank, your retained earnings, etc. But here’s the catch… issuing equity shares isn’t all rosy. It’s an expensive and time-taking affair. Issuing more equity shares also means giving a piece of your assets-pizza to someone else, i.e. diluting your ownership and profits. And it doesn’t make much business sense for you. But, as mandated by the RBI, you’ll have to maintain the Tier 1 capital as a certain percentage of the loans you’ve given. And that brings you to a catch-22 situation!

However, there’re these Basel III norms that provide you with some leeway. They allow you to maintain the required capital level with the use of some ‘additional’ Tier 1 Capital Instruments (AT1), which are not equity but can be considered close enough. And out of these instruments, you, following the Indian banks’ conventional practice, chose ‘Perpetual Debt Instruments’ as your AT1 bonds. So, this introduces you to Perpetual Bonds (or Perps).

Now, you are like... “tell us more, Finology”. Well, okay.

Perpetual Bonds used to be immortal. Meaning, if someone had subscribed to these bonds of your bank, you don’t have any obligation to repay them until liquidation (winding-up) of your company. Oh, so these are like equity shares, you ask? Well, not exactly; you can call them quasi-equity instruments. Because, unlike equity, the perps holders don’t get a share of your company’s ownership and profits. Acha, so they might be entitled to some kind of interest on bonds? Well, Yes and No. What?

See, although these bonds do carry coupon rates, you, the bond issuing company, may opt NOT to pay the interest in case your capital ratio falls below a certain limit or if your bank is making losses and doesn’t have sufficient reserves. And what’s more is that if your equity in the Tier 1 capital falls below a certain level, you can actually write down the entire principal amount of the perps. Meaning, you will NO longer be required to repay the principal amount. And now you know why these perps are actually, sort of, free money for your bank.

But well, change the perspective and put yourself in the bondholder’s shoes.

Why invest in Perps, then?

So, let us first clarify, luckily enough, retail investors like you and me can’t (directly) invest in these perps. But yeah, you can still do that through debt mutual funds. Anyway, suppose you’re the institutional fund manager. To you, these perps will, obviously, seem good for nothing. Like neither your capital is safe nor the interest guaranteed. It’s kind of ‘risky as equity, disguised as bonds’. Then, why will you invest in these perps?

Well, to entice you, the banks exercised a clever bit of dressing-up.

So, what they did is offer a Call option along with these perpetual bonds. A call option is where the issuer of the instruments has the right to redeem the bonds (repay your money) before its maturity date. But well, banks said ‘right’ and NOT ‘obligation’. Meaning it’s their discretion whether to repay or not; you won’t have a say in that. However, they advertised this bit that the call option will be exercised in 5 to 10 years from the date of issue.

And they honoured their promises. It became such a customary practice that banks timely repaid your money and did the regular interest payments as well (because if they don’t, it would send a signal across the markets that the bank is into some kind of trouble). And now you know why debt fund managers used to reliably bet on these perps.

As a result, the mutual funds managers also advertised the debt funds (containing perps) to retail inventors, saying that these will offer them extra return over the substitutes like bank FDs, etc. And that ‘extra’ bit worked quite well until last year.

It was a time when things went bad inside Yes bank. It wasn’t able to sustain its business, let alone its capital ratios. Just so you know, for you, there is also a nasty surprise from the RBI, where it can direct a bank to write down (cancel) the entire value of AT1 bonds if it feels that the bank is no longer viable and needs public sector capital infusion.

And when Yes bank’s financials (FY20) went bust, the RBI exercised its power and Yes bank had to write down (cancel) more than Rs 10,000 Crores of its issued AT1 bonds. Ouch!!

You will argue that how is it possible, as generally, bonds are considered superior to equity and get priority over them in case of liquidation. Well, FYI, this wasn’t a ‘liquidation’, but a ‘resolution’. In a resolution, the bondholders might have to take a haircut. And with perps, things are even worse!

Anyway, the essential bit that fund managers were missing out was that, although perpetual bonds are those (immortal) ‘bonds that live forever’, but the bank whom you have asked to keep your money forever, may NOT live forever (as in the case of Yes bank)! After all, these banks aren’t exactly immortal, right? And now you know why these perps have been the talk of the town for a while now.

Finally, SEBI steps in…

In a bid to ensure that no more investors are played into this perps trap, the market regulator SEBI came up with two announcements last month --

• Perpetual bonds can not occupy more than 10% of a debt funds’ portfolio.
• These will be valued with a maturity of 100 years from the date of its issue.

While the first one was aimed to curb debt funds’ exposure towards these highly risky bonds, the second had something to do with perceived risk and valuation. See, if we tell you there is one bond that’ll be repaid in 10 years and another that’ll be repaid in 100 years, which one do you feel is riskier? Well, obviously, the second one, because you have no idea what’ll happen in the coming 100 years, that’d be as good as never seeing your money! So, you’ll obviously demand the riskier bonds at a cheaper price (valuation).

Hence, by increasing the maturity of perps to 100 years, SEBI wanted everyone to realise that these are actually very risky and over-valued investments.

But not everyone is happy with this announcement! Think of the fund houses. If this valuation rule is implemented, existing mutual fund investors will panic, and the price of the bonds will plummet overnight. Everyone will knock the fund manager’s door to liquidate their holdings. But where will the fund manager get the money to repay them? Because remember, the perps might not have matured yet!

So, the SEBI has allowed a year for existing investors to back out. Subsequently, the valuation rules will be effective.

Anyway...

What do you think? Will this work out? Tell us in the comments below.

The Bottom Line

Well, we won’t say much because this entire story was learning for all of us. But there is this one thing which we want to remind you, dear investing enthusiasts. Don’t blindly bet on assets. Diligently carry out the homework and only then test the waters. And we leave it to you with this simple yet effective line that we wrote in a previous blog as well --

“Invest in what you know".