Explained: What are perpetual bonds & why have new Sebi rules irked FinMin?

Sebi's new rules around mutual fund (MF) investments in these bonds have kicked up a storm

Market regulator Securities and Exchange Board of India’s (Sebi’s) new rules around mutual fund (MF) investments in perpetual bonds have kicked up a storm. But what are perpetual bonds, who issues them and why are MFs an important part of the ecosystem? Let’s find out.

What are perpetual bonds?

A typical bond has a fixed tenure of maturity, but perpetual bonds, as the name suggests, can theoretically go on for as long as the issuer is a going concern. In practice, though, these bonds have a “call” option, which enables the issuer to redeem the bond at pre-fixed intervals. The call may not get exercised if the issuer sees market interest rates to be higher than the coupon of the perpetual bond. An investor in a perpetual instrument can get his principal back by selling the bond in the secondary market, or when the issuer decides to redeem the bonds. 

Are these bonds risky? If so, why?

In India, banks issue perpetual bonds to meet their capital requirements under the Basel III norms (globally followed accounting norms that require banks to maintain a certain capital base at all times to withstand financial shock). Lenders could issue these bonds to raise Additional Tier 1 (AT1) capital, which acts as a component of core equity for a bank. The main element of risk stems from the fact that the issuer of these bonds has an obligation only to pay interest and is not required to repay the debt. Since the AT1 bonds are subordinate to debt instruments and only senior to common equity, these are considered quasi-equity for banks.

Therefore, the risks associated are higher than with debt but marginally lower than equity. If its capital situation deteriorates, the bank can skip paying interest on these bonds. In case of a loss, the bank is not allowed to dip into past reserves to pay interest towards these bonds. Last year, as part of a package to rescue Yes Bank, AT1 bonds worth over Rs 8,000 crore were written off even before equity. This was when these bonds shot into the limelight.

Why would someone invest in these bonds?

As these bonds are riskier than other debt instruments, the issuer has to pay a higher interest/coupon rate. Typically, the spread between AT1 bonds and normal debt issued by the same issuer is at least 50-75 basis points higher. The higher interest rates make investing in these bonds attractive for an investor with a high-risk appetite. Investing in such debt instruments is also an attractive proposition for mutual fund debt schemes that aim to generate higher returns.

Why are perpetual bonds in the news again?

On March 10, Sebi issued a circular capping MF exposure to such bonds. Under the new rules, no fund house can under all its schemes hold more than 10 per cent of overall perpetual bonds issued by a single issuer.

At an individual scheme level, exposure to single issuer of such bonds cannot exceed 5 per cent of the total corpus and overall exposure to such bonds is capped at 10 per cent of the scheme corpus. The regulator said the maturity date for such bonds should be considered 100 years.

The new rules were aimed at safeguarding investors in debt MFs who are big subscribers to perpetual bonds issued by banks. According to an estimate, banks have issued AT1 and tier-II bonds worth Rs 3.5 trillion. A fifth of these bonds is held by MFs. Of the outstanding AT1 issuance of Rs 90,000 crore, more than Rs 35,000 crore are held by MFs, according to a note by the finance ministry. At present, there are no specified investment limits on MFs when it comes to investing in these bonds. Sebi is of the view that as these instruments are riskier than other debt instruments, therefore prudential investment limits need to be put in place. The circular has become controversial after the finance ministry, through a letter, objected to certain proposals.

Why have the new Sebi rules irked the finance ministry?

The new limits imposed by Sebi will constraint incremental MF investments in AT1 bonds. These could impact the fundraising plans of banks, particularly those in the public sector. “Capital raising by PSU banks from the market will be adversely impacted due to limited appetite from other investors. These would lead to increased reliance on government for capital raising by PSU banks as AT1 and Tier 2 would need to be replaced by core equity,” the finance ministry wrote in the letter to Sebi. Further, the 100-year valuation norm would make the issuance of these bonds expensive. The higher the tenure, the greater has to be the yield. Currently, MFs consider the call date for valuing these bonds.

What is the way out?

Sebi’s new rules come into effect on April 1. The new investment cap will be applicable to only fresh investments. However, existing excessive investments are allowed grandfathering. Sources suggest that Sebi is working on tweaks to assuage concerns raised by the finance ministry and the MF industry.