All you need to know about perpetual bond controversy

A circular from SEBI on perpetual bonds in the second week of March set off tensions between the Finance Ministry and the market regulator and sent debt mutual fund investors into a tizzy once again. While the circular intended the changes to take effect from April 1, 2021, SEBI has now decided to give funds time until April 2023 to fall in line with the valuation rules.

Perpetual bonds are fund-raising instruments that do not carry any maturity date as bonds usually do. Instead, they offer to pay their buyers a coupon or interest at a fixed date for perpetuity. While a variety of entities may issue perpetual bonds, the most common ones in India are issued by banks to meet their Basel III capital norms and are called Additional Tier 1 or AT-1 bonds. In the case of bank AT-1 bonds, banks can write off the principal in addition to not paying interest if they run short of capital or face bankruptcy. For an investor, this feature and the eternal nature of these bonds add to the risk; but they usually fetch higher yields than other debt instruments.

While the principal amount in such bonds is never really due for repayment, issuers do attach a call option. So, at the end of a specific term, say five or 10 years from the issue date, the issuers can buy back the bonds from the investors. Investors can also use the secondary market as a means of exit in the case of traded perpetual bonds.

Given the higher risk appetite required for such instruments, SEBI has restricted the purchase of such bonds to institutions. Debt mutual funds with retail investors in them however own such bonds. After the recent write-off of AT-1 bonds of YES Bank and its consequent effect on debt mutual funds, SEBI, in March, decided to further protect retail investors in debt funds by setting a 10 per cent limit for a debt fund’s investment in such bonds. It also laid down that funds need to value these bonds as if they were 100-year bonds and, if illiquid, to reflect their true risk.

Bonds are valued by discounting the future interest receipts and principal repayments to present value. Today, fund houses value perpetual bonds assuming that their issuers will exercise their call options five or 10 years from the issue date. But SEBI wants fund houses to value them as if the principal will be returned only a 100 years later. Following this tweak in norms, perpetual bonds not traded frequently may see a sharp fall in value.

Not only will this change in valuation norm lead to significant volatility in the NAVs of several debt schemes, but the calculation can itself be cumbersome. Take the case of non-traded or thinly traded perpetual bonds. SEBI classifies debt securities with a trading volume of less than ₹5 crore in a calendar month as thinly traded. Perpetual bonds that fall into this category may need to build a risk-free benchmark and identifying a 100-year benchmark can be tough. The Finance Ministry appears worried about the circular because with stiffer valuation norms and the 10 per cent limit on debt scheme exposures, public sector banks may find it tougher to raise capital through this route.

While the fund houses have their work cut out, investors in debt schemes may have their troubles too if they own schemes with large perpetual bond exposures as their returns may get more volatile. Prices of perpetual bonds in the market have already tanked sharply in the last couple of weeks after the SEBI circular. Since the circular mandates the valuation to be updated by April 1, debt schemes that have higher exposure to thinly traded perpetual bonds may need to wind down this exposure or revalue these bonds causing NAV blips. A CRISIL Research report has found that 36 debt schemes from 13 fund houses held more than the SEBI-mandated limit of 10 per cent in perpetual bonds.

Their name may be bond, but perpetual instruments are almost as risky as stocks.

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