Investors who have bought perpetual bonds of Banks that could recall the bonds due to their NPA issues can see either a positive or a negative impact, depending on the price at which they have bought the bonds. Investors who have bought the bonds at face value or discount to face value due to spike in yields of the bonds will see a positive impact as the bonds will be recalled at face value. Investors who have bought the bonds at a premium to face value would lose money as they have to write off the premium immediately.
The recall of bonds also highlights the risk of perpetual AT1 bonds, which was pushed aside by investors as they lapped up all primary issuances of the bonds given higher levels of yields and spreads and comfort of government ownership. Liquidity vanished for the bonds on their NPA issues, briefly came back on bank recapitalisation plan of the government and again vanished after the PNB scam.
Pricing of these bonds were vague as the banks had an option to call back the bonds any time after five years from issue data. Call option pricing for bonds in India is extremely difficult given the inadequacies of yield curves.
Public sector banks that are under RBI prompt corrective action list are likely to recall their perpetual bonds (AT-1, additional tier 1), issued under Basel-III capital norms, AT-1 bonds, also known as perpetual bonds, are sold by banks with an option to call at the end of 5th or 10th year. Recall takes place on any regulatory event.
As per a report by ICRA, AT-1 bonds worth Rs 376 billion can be re-called by banks. ICRA in its report said, two public sector banks Bank of Maharashtra and Oriental Bank of Commerce have already issued notices to their AT-1 bondholders, about an exercise of an early call option on their AT-1 bonds. AT-1 bonds can be recalled before the date of a call option if there is a regulatory event, and these are replaced with similar or better quality capital. RBI has confirmed that capital infused under the recent recapitalisation programme can be utilised to replace the existing AT-1 bonds and subsequent instructions from the government to recall their AT-1 bonds, have triggered early calls by banks.
As per ICRA report, PSB banks had AT-1 bonds outstanding worth Rs 603 billion, Out of the banks that are currently under the PCA or are likely to come under PCA, about 60% of AT-I bonds totalling Rs 376 billion can be recalled earlier. 11 out of 21 PSBs have been placed under the PCA framework (banks under PCA framework cant expand its loan books).
Why Banks can recall AT-1 Bonds
In past years public sector banks had raised AT-1 bonds worth Rs 603 billion to improve there Tier 1 capital ratio (Tier I is regulatory capital. It consists mainly of share capital and disclosed reserves. Tier I components are deemed to be of the highest quality because they are fully available to cover losses Hence it is also termed as core capital. Basel-III Tier-I non-equity capital comprises preference shares and perpetual bonds.Tier I capital has two components, Common Equity Tier I and Additional Tier I.It is a going-concern capital that means banks can absorb losses without triggering bankruptcy.) With huge losses, public sector banks ability to service coupon payment for AT-1 bonds is difficult, as the bond can be serviced through profits for the year or accumulated profits. Therefore with early recall risk of skipping coupon payment will be reduced.
Perpetual Bonds
Fixed income securities or bonds are instruments which have a cash flow according to a predetermined rate of interest, paid according to a predetermined schedule.
Usually most of the bonds have a definite maturity period but if a bond has no maturity date it is known as a perpetual bond. Perpetual bond has cash flows to perpetuity; issuers pay coupons on it forever,also issuer don’t have to redeem the principal unless the bond has a call or a put option.
Advantage to an Issuer
Perpetual bonds issued by fiscally challenged government gives the advantage of raising money without ever needing to pay back. Corporates issue them as they just need to pay the interest which is tax deductible expense and the principle is never paid unless it has a call or a put option.
Advantage to an Investor
These bonds offer relatively higher coupon rates than normal bonds as they don’t have a maturity. Investor may prefer these bonds because they offer steady, predictable source of income over a considerable long period of time.
Investing in these bonds during falling interest rate scenario is beneficial as in terms of better yield and capital appreciation.
Risk associated with Perpetual Bonds
Perpetuity keeps investor exposed to credit risk for a longer period of time. Bond issuers such as governments, PSUs and private corporations, can face financial trouble or default due to economic downturn. It also exposes the investor to liquidity risk as they cannot redeem them before the call option or put option.
The bonds too are not priced correctly if there are no vibrant yield curves to price put or call options. By default in India they are priced to call, which is not the right way to price the bonds.
In India banks and other financial sector companies issue perpetual bonds. Banks require the capital to meet their Additional Tier-1 capital needs as per Basel-III guidelines. In 2014 Bank of India issued perpetual bonds of Rs 25 billion at 11% coupon rate and call option at 10th year.In June 2016 bank issued perpetual bonds of Rs 15 billion at 11.5% coupon rate and call option at 5th and 10th year.In August 2016 these bonds traded at levels of 10.77%
Other PSU banks such as United Bank, IDBI, Canara Bank and IOB have raised funds through perpetual bonds. Other financial sector companies like Capital First, Cholamandalam, Tata Capital and DHFL have also issued these bonds.
To implementation of Basel III Capital Regulations, banks need to improve and strengthen their capital plan so they can issue perpetual debt instrument (PDI) as additional Tier 1 instruments,As per RBI these instruments will be subjected to a lock-in clause in terms of which the issuing bank not to liable to pay interest, if the bank’s CRAR (Capital to Risk (Weighted) Assets Ratio) is below the minimum regulatory requirement prescribed by RBI,the impact of such payment results in bank’s capital to risk assets ratio (CRAR) falling below or remaining below the minimum regulatory requirement prescribed by RBI;However, banks can pay interest with the prior approval of RBI when the impact of such payment may result in net loss or increase the net loss, provided the CRAR remains above the regulatory norm.
In May 2011 Tata steel issued 11.50% semi-annual coupon perpetual bond with call option at the 10th year.
Predominantly long term investors such as provident funds or insurance companies are investors in these bonds. Individual investors can also invest in them. Tax need to paid on interest income generated from perpetual bonds as per investor’s tax bracket.
How to value a Perpetual bond
Consider a perpetual bond with a 10% annual coupon and yield 8%, then price is calculated as
Price = Interest payment/yield=10/0.08=125
If bond has call or put option then its price is calculated to put or call. Ideally the option pricing will determine the value of the bond.
