Perpetual bonds – where do we go from here?

It has been over a month since SEBI announced guidelines for perpetual bonds and almost a month since the valuation of such bonds under the new methodology has been implemented. Before we get into implications of such valuation, lets quickly understand what these bonds are, and how did they actually impact market sentiment.

AT-1 (additional tier 1) bonds are issued predominantly by banks to raise additional Tier 1 capital without any maturity date (perpetual), but they have a call option. Banks issue AT-1 bonds to meet their capital adequacy requirement. Higher capital adequacy norms came into force with the implementation of Basel III guidelines.

These guidelines were formed after the 2008 financial crisis with the collapse of a few banks and financial institutions. Similarly, Basel III Tier 2 bonds issued by banks are expected to provide to their depositors and senior creditors an additional layer of protection.

According to the Basel III guidelines issued by the RBI, Basel III-compliant Tier 2 bonds normally come with a finite maturity.

The regulation

On March 10,SEBI put certain restrictions on investment in these bonds by Mutual Funds – no mutual fund under all its schemes shall own more than 10 per cent of such instruments issued by a single issuer; mutual fund scheme shall not invest (a) more than 10 per cent of its NAV of the debt portfolio of the scheme in such instruments and (b) more than 5 per cent of its NAV of the debt portfolio of the scheme in such instruments issued by a single issuer; and the investments of mutual fund schemes in such instruments in excess of the limits specified may be grandfathered, and such mutual fund schemes shall not make any fresh investment in such instruments until the investment comes below the specified limits. Given that mutual fund ownership of such Tier 1 bonds was around one-third of the total outstanding, it did create some anxiety across the perpetual bond segment.

Yields on such bonds shot up by ~1 per cent. The assumption here was MFs will panic exit such bonds and, hence, bids started inching up.

The volatility in perpetual bond space we saw was largely due to the uncertainty around the impact of valuation methodology. It is important to keep in mind that this in no way was a credit event, but a valuation method change for mutual funds. Since then, the yields have only softened (eased by 50-60 bps) from peak levels as carry chasers stepped in to buy such bonds. Also, we did not see mutual funds undertake panic sales, as the regulator has allowed grandfathering of such exposures.

What’s next?

Markets have now reconciled to business as usual with regard to perpetual bonds. It is important to note that the regulator has not barred MFs from investing in such bonds. Hence, the option remains with MF managers whether or not they would want to own such bonds. All perpetual bonds cannot be categorised as one. Like every debt instrument, perpetual bonds should be evaluated based on the banks fundamentals.

The primary focus remains to evaluate such bonds basis the underlying credit metrics, capital adequacy ratios and systemic importance to the Indian economy. As an investor, one needs to follow the same process in case he/she has exposure to AT1 bonds directly or via mutual funds. The current interest rate scenario may mean adequate liquidity and range-bound interest rates.

In such a scenario, carry yield in fixed income assumes a lot of significance. Such bonds do offer a spread over plain vanilla bonds. The acid test, however, would be to see how the appetite is if banks issue fresh bonds. Also, with valuations now being delinked from call option date, will banks want to continue to hold on to the existing bonds rather than exercising a call option on such bonds?

Markets will get more clarity over next few months as some tier 1 bonds approach their call date. However, market activity in such bonds so far is suggestive of call option being exercised, though it will have to be a wait and watch.

To sum up, AT1 bond offers credit comfort (based on underlying) and reasonable accruals for the investor. In case of MFs, it would best left to the discretion of the portfolio manager to hold the AT1 bonds till call/maturity as per the investment contours of respective schemes. Investors should be aware of the nature of the underlying investment rather than any action based on external noises. After all panic leads to pain, no one really stands to gain.

(The writer is CIO - Debt & Head - Products, Kotak Mahindra Asset Management Company. Views expressed are personal and do not reflect the views of Kotak Mahindra Asset Management Company Limited)

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