Last March, investors holding Yes Bank’s Additional Tier-1 bonds or unsecured perpetual bonds worth Rs 8,415 crore got a rude shock when these were written-off.
Perpetual bonds, as the name suggests, have no maturity.
There was much angst, but the terms of issuance showed the action was legitimate. This put the spotlight on the risk associated with perpetual bonds, with nearly Rs 1 lakh crore of such paper outstanding. It also sparked a debate on the use of such an instrument and the need to define financial metrics for issuers so that bondholders were not put at risk again. The possibility of even the government writing off these bonds in case of a distressed public sector bank issuer opened up. In short, both issuers and investors were rattled.
A year of nothing
Retail investors, who reportedly suffered losses of about Rs 1,000 crore in the Yes Bank bond write-off, had to be kept out. So, the new rules restricted entry to those investing Rs 1 crore or more, up from Rs 10 lakh earlier. However, the norms for mutual funds announced last week, while clearly aimed at safeguarding the interests of investors, come surprisingly a full year after the Yes Bank episode, almost as if to mark the anniversary.
More surprisingly, even after having 12 months to study the issue, market regulator SEBI has made a mess of it. Clearly, the mutual fund industry was not on board and the Ministry of Finance calling for a revision of the duration clause undermines SEBI’s authority.
One always thought consultations between various arms of the government—RBI too should have been consulted in this case, given the issuers fall under its domain—was a done thing. In fact, it is assumed that regulators engage with each other on myriad issues. Why not on this one then? Also, I may be wrong if this is the practice, but couldn’t the views of the Ministry of Finance have been conveyed to the regulator through more informal channels? The entire episode shows up our regulatory system in poor light.
The big bone
The root cause or clause that’s got the mutual fund industry worried and spurred the Ministry of Finance into action is the prescribed duration of the perpetual bonds. This reads: “the maturity of all perpetual bonds shall be treated as 100 years from the date of issuance of the bond for the purpose of valuation.” This is in stark contrast to the market trading these bonds on period to call option exercise date basis, which is usually 3-to-4 years from the issuance date.
(The call option means that each bond will pay interest up to its call date - which is the date on which the issuer can call back the bonds and pay the investors. The bank may choose not to call in the bonds and reset the call option to a particular date in the future)
The Ministry of Finance contends that the move will disrupt the market for perpetual bonds—currently at Rs 90,000 crore with Rs 35,000 crore worth held by mutual funds. Net asset values of mutual funds could drop sharply due to mark-to-market adjustments causing panic in the debt market. The MoF communique adds that the move will also diminish mutual funds’ appetite for such instruments, thus hurting issuing banks and increasing the burden on the Government to infuse more equity into public sector banks.
In its concluding para, the memo suggests that the revised valuation norms requiring tenor to be treated at 100 years be withdrawn.
The ball is now in SEBI’s court. Will it play ball?
In a seemingly conciliatory communication issued by the mutual fund industry body, AMFI, it was argued that the perpetual bond market in India is reasonably active and hence the market price should be used as the basis of valuation. The communication supported SEBI’s objective of fair valuation, but contended that: “Most trades in perpetual bonds happen on a yield to call basis. This is based on the established market convention, locally as well as globally, that the issuer will exercise the call option on the due date.”
The duration implication
Whether SEBI will revise its norms to take the market rate as the basis of valuation or devise a new formula is yet unclear, but let’s try and understand the duration aspect to get a sense of what’s at stake.
Before we get into what impact duration can have, a big caveat: I’m not a bond market expert, far from it. This here, is just an indicative illustration for the uninitiated to highlight the impact it has and doesn’t purport to be a lesson on bond pricing.
Pricing of bonds is mostly based on the present value principle, quite like in a discounted cash flow, where future receipts of interest are discounted at an expected return rate to arrive at the price. The terminal value is taken as the redemption value of the bond, which would mostly be the principal amount invested.
In our illustration, we use a perpetual bond of Rs 1,000 face value that has a coupon of 6.5 percent and a call option in three years. We also take the 2024 g-sec (government security) yield and the 2035-year g-sec yield as the discount rates—no adjustments, remember we are keeping it simple.
The yield on the 2024 paper is a tad over 5 percent, while that on the 2035 year paper is closer to 7percent. This clearly indicates that a longer duration paper will need to offer a higher yield. Now, in the absence of any 100-year benchmark, we assume a proportionate increase in yield based on the 2024-to-2035 differential to arrive at a tad over 10.7 percent.
What do these yield expectations and durations do to the price of a listed bond? As the coupon of 6.5 percent is higher than the expected yield of about 5 percent for a 3-year paper, the bond trades at a premium in the first instance, at about Rs 1,040. In the second case, as the coupon offered is lower than the expectation, the bond trades at a discount at about Rs 950. And in the last instance, of a 100-year bond, the price slumps to about Rs 600.
From a mutual fund perspective, this means that a paper that was valued at Rs 1040 while computing the NAV could be revalued down to Rs 600 if the duration was suddenly extended by about 90+ years. The move could cause other complications too, in terms of pricing such bonds by issuers. How do you marry a coupon of a 3-year paper with a 100-year paper?
Good intent, not action
One would bat for SEBI in taking steps to ensure that mutual funds limit their exposure to risky perpetual bonds, especially since they manage moneys of several small investors. In fact, exposures even lower than 10 percent would seem more prudent. After all, investors would be better off earning 2 percent less than 100 percent of that investment being written off.
That said, the valuation of perpetual bonds is surely something that needs a closer look, as it will eventually hurt existing investors in the schemes holding such paper too. Though, the bigger message from SEBI to mutual funds in this entire episode could be: stay clear of perpetual bonds. And that’s a signal I won’t argue with.
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