Perpetual Bonds: What a Catastrophe!

As the Yes Bank crisis unfolded, which involved write-off of the perpetual bonds worth about 8,700 cr issued by the bank earlier, jittery investors suddenly realized that Additional Tier 1 (AT1) bonds are worse than even equity!

Such an assumption stemmed from the fact that equity of Yes Bank was maintained intact, while it was only the perpetual bonds that were permitted to be written off by the regulator, Reserve Bank of India (RBI). The investor’s money under fixed deposits of the bank too was maintained intact except for a temporary restriction on withdrawal. The Yes Bank saga has no doubt suddenly turned the focus on AT1 bonds. 

Before getting into the details of the current storm around peps, first things first. It was the failure of a bunch of global banks during the global economic crisis of 2008 that led regulators to formulate the Basel III norms to improve the quality and quantity of regulatory capital of banks.

Taking a more prudent stance, RBI directed Indian banks to maintain a minimum total capital ratio of 11.5%—including a capital conservation buffer of 2.5%—of total risk weighted assets split into Tier1 capital of 8% consisting of equity, reserves, etc., and Tier 2 capital of 3.5% consisting of supplementary reserves and hybrid instruments. It is to meet these Basel III norms that banks have come up with the novel idea of raising capital by issuing “unsecured subordinated perpetual non-convertible bonds”. And Indian banks too, taking a liking to the concept, said to have issued perpetual bonds to the tune of about 84,000 cr to meet their capital requirements under AT1 of the new regulations. 

As the name indicates, these bonds do not carry any maturity date. They, of course, offer to pay a coupon or interest to buyers of the bonds at a fixed date perpetually. As they are of perpetual nature, issuers usually offer higher coupon rate than the prevailing rates on banks’ fixed deposits, etc.

However, these bonds come embedded with varied risks. The first and foremost is the default risk: banks can write-off the AT1 bonds and also stop paying interest if they run short of capital or face bankruptcy. Some issuers may attach a call option to these bonds, which means they can buyback the bonds at the end of the specified period of say, 5/10 years after the issue date. But issuers seldom exercise this option, for interest rates may not fall so drastically to make the bonds expensive for them. 

Investors can, of course, exit from these bonds by trading in secondary market. But in a scenario of rising inflation/interest rates, they are to be sold at a discount to the face value. Thus, investors in these bonds suffer from inflation/interest rate risk. 

It is the Yes Bank crisis—write-off of its AT1 bonds and its impact on the debt mutual funds—that awakened the SEBI to the complexity of these bonds, particularly their valuation. Once alerted by it, as a first step to protect retail investors in debt mutual funds, SEBI imposed a limit of 10% for debt funds to invest in AT1 bonds. Secondly, noticing a lacuna in the valuation of these bonds by MFs, SEBI ordered them to value these bonds as if they were 100-year bonds as against their current practice of valuing them, assuming that issuers would exercise their call option of 5/10 years to reflect their true risk. 

This has obviously stirred up a hornet’s nest: MFs have raised a hue and cry, for the net asset values of several debt schemes are likely to get eroded drastically if this method of valuation is adopted now. Finally, being frantically lobbied by debt MFs that were about to lose heavily, the Finance Ministry requested SEBI to review the instructions given for valuation of AT1 bonds. 

Accordingly, SEBI has now proposed to reset valuation in three phases: till March 2022, residual maturity of AT1 bonds may be valued at 10 years maturity from the date of issue; during the first half of 2022-23 residual maturity will be reset to 20 years; in the second half of 2022-23 it will be extended to 30 years and finally, from April 2023, bonds will be valued at 100 years maturity. 

This rearrangement will, of course, give the much-needed succour to debt MFs, but this whole fiasco posits a battery of questions: How is it that the MFs did not realize this simple valuation challenge and its impact on their NAV while investing in these bonds? How the rating agencies failed to take cognizance of the embedded risks while rating these issues? And, how the regulator, SEBI failed to anticipate the complexities of Peps? 

Ironically, SEBI has now imposed a fine of Rs 25 crore on Yes Bank for mis-selling additional Tier -1 (AT-1) bonds to individual investors—“devious scheme to dump the At-1 bonds on their hapless customers”—after the Yes Bank has written off the entire amount collected through these bonds from their books, to be more precise, after the investors lost their investment in full once for all.  It has also penalised three bank executives, who are held accountable for misleading retail investors.  It is said that the marketing team of Yes Bank misrepresented the bonds as a “super fixed deposit” and sold them as being “as safe as an FD”. This awakening of our financial market regulators after the damage had been inflicted has almost become a routine. So, the only option the investors have is: enquire, probe, read the prospects thoroughly well before committing money for new kinds of investments. 

And of course, the last yet an important question is: How NPA-saddled PSBs will now shore up their Tier 1 capital?