Bank Perpetual Bonds: What you need to know before buying

Published: June 9, 2020 at 10:36 am

Last Updated on

Several banks offer high-yielding perpetual bonds. In this article, we discuss the basics of a perpetual bond and what investors need to know before buying them.

What are perpetual bonds?

In simple terms, Perpetual Bonds are like a debt instrument that pays you interest. Investors are attracted to consider these bonds as the interest rate (coupon) being offered is considerably higher than other available investment options.

As the name suggests these are bonds that have no maturity date. The bond issuer would keep paying interest (if possible!) and the only way to get the principal back is to sell it in the secondary market or wait for the issuer to call back the bond (the dates would be mentioned with the issue). Perpetual bonds were introduced after the 2008 crisis to help banks raise the required funds.

Do Perpetual Bonds come with guaranteed interest payment & capital protection?

No. These bonds are unsecured, subordinated and perpetual
a) “unsecured”: There is no underlying asset or guarantee for the issuance of these bonds.
b) “subordinated”: In the event of liquidation/restructuring, the Fixed Deposit Holders of the bank gets preference over these bondholders. Hence, these bonds are are ‘subordinated’ to Fixed Deposit Holders.
c) “perpetual”: They are issued for ‘forever’. The principal amount invested is not mandatorily required to be returned back to the investor.
d) “non-convertible”: Investors cannot get shares in lieu of bonds, in the event of a restructuring.

You may have heard of Yes Bank AT1 bonds. These are perpetual bonds. When the bank was in trouble RBI via its draft restructuring proposal allowed the cancellation of outstanding AT1 bonds worth Rs. 8,415 crores!  The mutual funds which held these had to mark down their value. Various stakeholders including MFs have taken the matter to court.

What are the features of perpetual bonds?

  • Generally, minimum investment (lot size) is Rs. 10 lacs.
  • Higher Interest rates than FD and other debt instruments from the same bank.
  • Listed on Stock Exchanges.

What are the risks associated with perpetual bonds?

(1) The bonds are optionally callable i.e. the Issuer has the choice whether to return the capital or not. The issuer may call them (return your principal back) or the issuer may choose to.

According to the RBI guidelines for “Criteria for Inclusion of Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital” (page 200), there may be no pre-determined date of return of capital.

Banks must not exercise a call unless:
(i) They replace the called instrument with capital of the same or better
quality and the replacement of this capital is done at conditions which
are sustainable for the income capacity of the bank; or
(ii) The bank demonstrates that its capital position is well above the
minimum capital requirements after the call option is exercised.

(2) Interest need not be paid regularly!  (3) If the Capital Adequacy Ratio of the bank falls below a threshold, even the face value of the bond can be lowered! (4) If the bank collapses, these bonds could go to nought while shareholders are not affected as much!  All these factors make perpetual bonds riskier than equity!

Why do banks issue perpetual bonds?

  • By issuing Perpetual Bonds, Banks can meet their capital requirements as prescribed under the Basel 3 guidelines.
  • These bonds help the issuers to absorb Losses. Losses can be absorbed by banks through partial write-down or complete write-off if required.

What are the Regulatory Provisions?

Interest Payment: The issuer can reduce the interest payout can up to 60% of the promised rate or SKIP the payout in case of: Losses or no reserves!

Return of Principal can be halted if:

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The balance sheet may not reflect deterioration in certain financials, but if, RBI believes that a bank has reached a Point of Non Viability, these bonds can be written off. (In case of Yes Bank- The balance sheet did not reflect the erosion of Capital at the time when these bonds were been written off. The matter is with courts)

The prospectus may have a clause stating the “write off cannot be restored even after the point of non-viability is over”.  (Page No. 86)

Since these are perpetual bonds, isn’t it good that I will get a higher interest for eternity?

Generally, the call option is exercised after 5 or 10 years. Also, the higher interest is not guaranteed as mentioned above.

What you need to know before buying:

  • These bonds get redeemed only at Face Value by the issuer! (Hence, think before buying them at a premium from the exchanges).
  • Bonds can be illiquid in the secondary market.
Screenshot showing the total traded quantity of perpetual bonds
Screenshot showing the total traded quantity of perpetual bonds
  • The interest payout is non-cumulative (if it has been skipped in one year, you won’t get the skipped payout in the next year)

Who can buy perpetual bonds?  Those who:

  • Follow the quarterly results (only to find out what will happen to your money, and be ready to jump ship early, if required and if you can)
  • Read the fine print- Ask for the ‘prospectus’. (Sample offer Page No 82 onwards)
  • Predict the quarterly results of the bank (NPA, Capital, P&L)
  • Guess the Governments’ Capital Infusion plans with certainty.

Won’t the government will come to rescue if something happens?

You cannot expect the government to play messiah every time. However, the government in the past has come to rescue and:

  • Allowed banks under Prompt Corrective Action to exercise the call option.
  • Allowed banks to use historical profits to pay interest (ideally, the interest for the current year can be paid from the profit of current year).
  • Infused capital so that banks can meet their interest and repayment obligations towards these bonds.
  • Allowed one-time payment of interest from statutory reserves.
  • RBI is willing to renegotiate the Yes Bank restructuring according to the Economic Times (though nothing is known for certain)

Global Practices:

The bonds issued in India are generally non-convertible, while several global companies issue convertible bonds, known as Co-Co bonds! China, Spain and Italy have had incidences where the buyers have had a rough ride holding these bonds.

How are additional tier 2 (AT2) bonds different from additional tier 1 (AT1) bonds?

We have only discussed AT1 (additional tier 1) bonds above. AT2 (additional tier 2) bonds also exist (page 207) but are not perpetual in nature; have a minimum duration of five years (callable after that); They are subject to the same repayment risks as for AT1 but in the case of a restructure have higher superiority than AT1.

Should you subscribe to them?

Consider the following:

  1. It will be helpful to understand about yield and bond pricing from these articles (other freefincal articles on bond and yield pricing) before taking a decision.
  2. Your portfolio may already include these bonds (eg. NPS portfolio has these bonds. Search with ‘perp’ in the file)
  3. Older bonds complying with Basel II norms are comparatively better as they may not have loss absorption feature (write off/write-down may be prohibited in them).
  4. Consider the tax implications. The interest is taxable as per your income slab.
  5. What % is 1 lot of Rs.10 lac of your total portfolio? It better be as small as possible!
  6. Not suitable for most retail investors. Not because of the lot size, but because they only want the return without the risk.

To summarize, the incremental interest being received by the investors should outweigh the risks perceived at the time of making the investment.

This article was written in collaboration with a commissioned writer who is from the financial services industry.

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