Synopsis- SEBI circular on perps has created a tremor in bond markets. Investors are at the receiving end on the fact that Finmin issued a directive to SEBI. Check out INRBonds risk rating on perpetual bonds.
Investments in perpetual bonds have to be made with full knowledge of risk and pricing. Unfortunately, investors are pricing bonds as if the call date is the maturity date and risk is not as much as equity risk. This will hurt investors badly when markets shun these bonds.
SEBI has told Mutual Funds to cap the exposure to perpetual bonds and also value them to maturity rather than to the call date. This has sent shivers to the MF industry as exposure of Rs 400 billion to such bonds, which needs to be marked down as the bonds were valued at call and has to be changed to 100 years. Bonds will also turn completely illiquid as no one will buy 100 years maturity bond. Media reports suggest that the Finmin has urged SEBI to reconsider the valuation norms.
The Finmin directive to SEBI, which is diligently trying to protect investors interest is a huge cause for worry. This can be seen by investors as if they do not have any regulatory safeguarfs on their investments.
As far are perpetual bonds are concerned, they are one of the riskiest instruments in the market and pricing is incorrect as they are not valued using option pricing models.
Latest circular on perpetual bonds issued by SEBI is in line with previous research conducted by INRBonds.com on these bonds. For details, please visit Perpetual Bonds are the Riskiest Instruments Available, Investors Beware.
In order to cap mutual funds exposure to perpetual bonds, SEBI has issued a circular which will be effective from 1st April 2021.
Salient features
Ø No Mutual Fund under all its schemes shall own more than 10% of such instruments issued by a single issuer
Ø A mutual fund cannot invest more than 10% of its NAV of the debt portfolio of the scheme in such instruments
Ø A mutual fund cannot invest more than 5% of its NAV of the debt portfolio of the scheme in such instruments issued by a single issuer
Ø For the purpose of valuation, the maturity of all perpetual bonds shall be treated as 100 years from the date of issuance of the bond
Ø Close -ended debt schemes shall not invest in perpetual bonds
Ø In case of perpetual bonds are written off or converted to equity without proposal, the date of write off or conversion of debt instrument to equity may be treated as the trigger date.
Immediate Impact on perpetual bonds
Ø Perpetual bond yield will start rising as liquidity dries up.
Ø Borrowing cost of these bonds will witness a rise
Ø As maturity of such bonds will be considered as 100 years, price of bonds will fall and duration will increase. Consequently, interest rate risk will increase
Impact of Debt mutual funds
Ø Debt mutual funds may have to sell these instruments in a quick time which may create bond price volatility
Ø NAV of debt mutual funds having significant exposure to such instruments will suffer a drop
Perpetual Bonds
Perpetual bonds are seen as good investments during low-rate scenario as they carry higher yields and provide high capital appreciation when yields fall. They are flavour of the day investments and as long the investor knows when to stop buying or exit the bonds, the investments will do well.
Banks issuing perpetual bonds carry high credit risk if banks capital adequacy goes below regulatory norms as banks then do not have to service bond holders through interest payments as the bonds get converted to equity.
Perpetual bonds also carry interest rate and liquidity risk as at times when interest rates start to rise, yields rise and bonds turn illiquid as markets do not buy into option carrying bonds given pricing anamolies.
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.
Risk in Perps
Perpetual bonds by nature are risky as they are callable and have many covenants that can hurt bond investors if banks loan books turn bad. Investors have already had experience of perpetual bonds being called prematurely, giving them capital loss if they had bought at a premium.
Many bonds are trading at discount to face value, again giving notional capital loss to investors who have bought the bonds at higher price and are holding the bonds or realized capital loss to those who have sold the bonds.
Perpetual bonds carry many risks including interest rate risk, credit risk, liquidity risk and pricing risk, Non institutional investors believe that by holding the bonds until they are called will given them the necessary yield they are looking for and also negate all risks, especially credit risk.
The question of credit risk throws up the perceived implicit support of RBI and the government, where banks are not allowed to fail. This can be both right and wrong. Weak government owned banks are receiving capital support from the government or are being merged with bigger banks eg. Dena Bank, Vijaya Bank with BOB and SBI subsidiaries being merged with itself.
On the private banks, ICICI Bank and HDFC Bank have been classified as too big to fail but will RBI allow other banks to fail? Until now it has not happened but it can always happen, as there is nothing that stops the RBI to let banks fail if they sink under bad loans. No bank has any guarantee from RBI or government though government banks have implicit guarantee.
Until Yes Bank, no private bank had failed, RBI ensured Global Trust Bank was merged and not allowed to fail but now with many banks facing bad loan issues, it may be difficult for RBI to protect all banks.
The risk levels of perpetual bonds are high and unless investors can evaluate the risk, it is best to stay off such bonds especially the weak banks.
As per the Basel III norms, banks have to maintain Tier-one capital at seven percent of risk weighted assets (RWA), Tier 2 at 2 percent of RWA and have to maintain their total capital ratio at nine percent.
Yes Bank Reconstruction Scheme
On the 5th of March 2020, after placing Yes Bank bank on Moratorium, RBI announces a scheme of reconstruction for Yes Bank, as lack of liquidity, capital and the absence of any credible plan for infusion of capital led to potential defaults by the bank on its debt obligations.
Unless otherwise expressly provided in the reconstruction scheme, all contracts, deeds, bonds, agreements, powers of attorney, grants of legal representation and other instruments of any nature, subsisting or having effect immediately before the appointed date, to be effective to the extent and in the same manner, as was applicable before the Scheme and same is applicable to all the deposits with and liabilities of the Reconstructed bank, the rights, liabilities and obligations of its creditors.
But the instruments qualifying as Additional Tier 1 capital, issued by Yes Bank under Basel III framework, to be stand written down permanently, in full.
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