Mutual funds (MFs) are lapping up perpetual bonds issued by public sector banks (PSBs), with the amount invested in such bonds rising nearly eight times in the past year. The assets of debt schemes in these bonds, also known as additional tier-1 bonds, have risen to about Rs 16,000 crore from Rs 2,000 crore a year ago, estimates from Value Research suggest.
PSBs are issuing these instruments in an effort to shore up their tier-1 capital, to comply with the Basel-III norms. These bonds offer a higher yield of 9-12 per cent, and are being added to their portfolios by debt funds to shore up returns. On the other hand, five-seven year
AAA-rated debt papers issued by PSBs are fetching anywhere between seven per cent and eight per cent.
Perpetual bonds have no maturity date and pay interest or coupon annually. The coupon is typically 200-300 basis points higher than the benchmark government bond yield.
There is a regulatory arbitrage available on the issuance of these bonds, according to experts. For banks, this is part of their tier-1 capital, which is closest to equity capital. And for the lender, this is treated as a pure debt security.
“These bonds are hybrid instruments but the MFs expect them to largely behave like fixed-income instruments. And, since the yields are attractive, the funds are building a position in these,” said Dwijendra Srivastava, chief investment officer–fixed income, Sundaram MF.

One drawback of these bonds is that they are not redeemable and another is the lack of liquidity, as MFs and insurance firms are the only two notable participants trading in these bonds. Last year, the Insurance Regulatory and Development Authority of India allowed insurers to invest in these bonds, if they were issued by banks with at least an ‘AA’ rating.
The other worry for bondholders is that banks can potentially skip the coupon payment. Banks are expected to make the coupon payments to their bondholders from their profits or revenue reserves. In case the banks are not profitable, they can pay the coupon from accumulated or statutory reserves.
“These instruments do not give the kind of comfort that a debt instrument should give, as the logic of issuing tier-1 capital is to absorb losses in case the bank gets into trouble. In case the problems within the banking system deteriorate, these instruments may see suspension of interest payment. We are not comfortable investing in such bonds unless the banks’ equity capital is sufficiently above the minimum regulatory requirement,” said R Sivakumar, head–fixed income, Axis MF.
Not everyone, though, is as apprehensive about a default in payments considering government support for PSBs. “Over time, if the non-performing asset problem worsens, some of the weaker banks issuing these bonds may feel the pinch. Still, the possibility of any bank defaulting on its payments is just a theoretical possibility at this point in time,” observed Manoj Nagpal, chief executive officer, Outlook Asia Capital.
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