Why Are Perpetual Bonds Trending Lately?

You have banks marketing perpetual bonds as a suitable investment for retirees seeking regular income. It offers a considerably higher rate of interest than bank fixed deposits. For instance, SBI provides a much higher interest rate on perpetual bonds than around 5.4% for bank fixed deposits of maturity ranging from 5-10 years. However, is investing in perpetual bonds of banks and NBFCs the same as putting money in their fixed deposits? 

What are perpetual bonds?

You may consider a typical bond as having a fixed maturity tenure. However, perpetual bonds have no maturity date. You have these bonds capable of going on for as long as the issuer remains a going concern. It means the company remains stable and continues with the business for the foreseeable future. 

However, these perpetual bonds have a ‘call’ option that allows the issuer to redeem the bond at a fixed price and date. Many issuers use the call option for the early redemption of perpetual bonds. For instance, the call option allows the issuer to buy back the bond after a specific period, such as five years. 

You have banks issuing AT-1 or Additional Tier 1 bonds, a type of perpetual bond to meet Basel III capital norms. It ensures that banks have a buffer of high-quality liquid assets to manage cash outflows during periods of short-term stress. In simple terms, it helps banks maintain strong balance sheets. However, it is an unsecured instrument being senior only to common equity.

You would find investors putting money in AT-1 bonds to earn a higher return than bank fixed deposits. However, SEBI has tightened regulations around these bonds. It allows only institutional investors to subscribe to these bonds with a minimum trading lot size and a minimum allotment size of Rs 1 crore. You will find many retail investors picking already traded AT-1 bonds from the secondary market on recommendation from relationship managers and brokers. 

Why do banks issue perpetual bonds?

You have many investors believing that perpetual bonds enjoy the guaranteed return of bank fixed deposits. However, banks issue perpetual bonds such as AT-1 to meet capital adequacy norms. Banks have the freedom to write off the principal and not pay interest on these bonds if they face bankruptcy. 

You may find banks that issue AT-1 bonds skipping the interest payouts for a particular year if capital ratios fall below specific threshold levels, as mentioned in their offer terms.

Moreover, RBI could ask banks to cancel the outstanding additional tier 1 bonds if they feel the bank needs to be rescued even without consulting the investors in perpetual bonds. For instance, RBI allowed Yes Bank to completely write-off AT-1 bonds as bondholders who invested around Rs 10,800 crore suffered a massive loss. 

Should senior citizens invest in perpetual bonds?

You have senior citizens subscribing to banks’ perpetual bonds to earn a higher return than bank fixed deposits. You may also find depositors in bank FDs insured up to Rs 5 lakhs for both principal and interest amounts in a particular bank. However, perpetual bondholders have no such guarantee even if the bank issues the bonds. 

Banks can skip interest payouts partly or wholly on AT-1 bonds if their capital falls below a regulatory requirement. Moreover, your principal amount itself is at risk if banks face severe financial pressure. However, you will never find banks defaulting on fixed deposits of investors. 

If you invest in a bank FD, you know the maturity date of your investment. Perpetual bonds have no fixed maturity, and your money remains with the bank for as long as it needs the funds. Moreover, agents mis-sell perpetual bonds as limited period bonds as they have a call option. 

Banks can decide when to use the call option and pay back your principal on a particular date or continue paying interest. However, buyers of these bonds believe that banks will exercise the call option after 5 or 10 years. If you are a senior citizen investing in perpetual bonds, you must treat this investment as a perpetual instrument. You cannot use this investment as an emergency fund compared to bank FDs that may be withdrawn prematurely with a minor penalty on interest. 

Should you buy perpetual bonds from the secondary market? A senior citizen who seeks the safety of capital and regular interest income must never buy perpetual bonds. You could purchase perpetual bonds from the secondary market. 

However, you may end up buying them at a high yield-to-maturity or YTM. As bond prices move inversely with its YTM, an increase in yield to maturity results in a fall in the bond price. In simple terms, bonds with a higher default risk compensate investors through a higher yield. 

Impact of perpetual bonds on debt funds

You may find a circular issued by SEBI, the capital market regulator, on March 15, 2021, causing a stir among investors in debt mutual funds. The mutual fund industry has massive assets of around Rs 35,000 crore in perpetual bonds issued by banks with 100 years. 

You have SEBI directing mutual funds to value perpetual bonds as 100-year instruments. It has also set a limit of 10% for investments by debt funds in these perpetual bonds, including AT-1 bonds and Tier-2 bonds. The circular would come into force from April 01, 2021. 

You may have noticed the tussle between SEBI and the Finance Ministry where the Ministry stated that there was no benchmark to value perpetual bonds at 100 years. It has requested SEBI to withdraw the circular relating to valuing perpetual bonds at 100 years. 

The Finance Ministry believes this provision could result in panic redemption by investors in debt funds and higher borrowing costs for banks when the economy was still recovering from the pandemic. It led to the rise in the yield of perpetual bonds issued by banks. 

You could find the net asset value (NAV) of debt mutual fund schemes holding perpetual bonds falling if bond yields rise. SEBI wants mutual fund houses to value perpetual bonds as if your principal amount will be returned only after 100 years. It could result in infrequently traded perpetual bonds, seeing a sharp fall in their value. 

You have many mutual fund houses valuing perpetual bonds based on the assumption that issuers would exercise the call option within 5 to 10 years. You will find severe volatility in the NAV of many debt funds if the SEBI rule valuing perpetual bonds as 100-year instruments goes through. 

SEBI has amended the valuation rules for perpetual bonds after a push from the Finance Ministry. It issued a circular where the deemed residual maturity of AT-1 bonds would be ten years until March 31, 2022. 

You would find the maturity increased to 20 and 30 years over the subsequent six-month period. However, from April 2023, you would find the residual maturity of AT-1 bonds becoming 100 years from the date of bond issuance. 

You may invest in any fixed-income instrument if you seek capital protection and regular income. It’s prudent for senior citizens to avoid investing in debt funds for higher return as the money’s safety is of paramount importance. Moreover, retirees must avoid investing in risky AT-1 bonds of banks and other issuers. In a nutshell, you may invest in any financial instrument that you understand to achieve investment objectives depending on your risk tolerance. 

For any clarifications/feedback on the topic, please contact the writer at cleyon.dsouza@cleartax.in

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