Recently, perpetual bonds have been in the news and many debt fund investors had questions pertaining to these bonds, debt funds and the impact of SEBI's new rules on investors.
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What are perpetual bonds?
Perpetual bonds are instruments issued by banks that do not have maturity date as other bonds usually do. These bonds offer perpetual interest at a rate that is fixed at the time of issuance. The banks issue these bonds to raise their capital that they need to carry in their balance sheets. The most common ones of these bonds are Additional Tier 1 (AT-1) bonds. These bonds come with an element of risk compared to other debt instruments as they are designed to be part of permanent equity for banks. The banks can write off the principal or skip payment of interest of these bonds if they face issues related to its capital. Hence, these bonds carry high risk and offer a higher interest rate to its investors.
The banks offering these bonds have a call option where they can buyback these bonds at any time or at the end of the specific period like 5 or 10 years. If the banks do not opt for the buyback of these bonds, then the bonds will continue perpetually.
Perpetual bonds carry all the three risk that can exist in debt investing:
Credit Risk – The Banks can write off the principal or do not pay interest if they go through tough times
Interest Rate Risk – Since there is no maturity for these bonds, the value of bonds will get impacted in case of an increase in interest rate. The sensitivity to the interest rate is much higher in these bonds
Liquidity Risk – Banks may choose not to opt for a call option and continue with the bond. However, Investors can exit from perpetual bonds that are trading on the secondary market whenever they wish.
Why these bonds are in news and how does it affect you?
A few days ago, SEBI came up with rules pertaining to perpetual bonds that were meant to work in the interest of investors and reduce risk. From the two crucial points in the rules, one was related to limiting the exposure to these bonds within the overall portfolio to 10 percent and limiting the exposure towards a particular issuer to 5 percent.
This step ensures protection for its investors given the experience with AT1 bonds during the fallout of Yes Bank. Close to 30 Mutual funds at that time had an exposure of about Rs 2,700 crore to the bonds of Yes Bank. These bonds were written-off completely resulting in huge losses to investors of those bonds. Hence, the rule on limiting the exposure will help to reduce such risk in future.
Another rule that raised concern was the change in the method of calculating the maturity of these perpetual bonds. These bonds are usually valued at price-to-call, this means that mutual funds have valued them as if they would be repaid on the call dates.
Typically, intervals of 5 to 10 years are considered as the maturity period and accordingly their maturity is set. SEBI’s new rule changed the valuation to 100 years maturity. This change makes perpetual bonds highly sensitive to interest rate changes. This also impacts the overall duration of the debt fund portfolio. Leading to an overall impact on the NAV of the funds holding such bonds and affecting investors investment as well.
However, SEBI came up with the amendment on maturity where they have put forward a glide path for the implementation of this rule to reduce its impact. Despite this amendment in the valuation rule, there will be an impact on the overall duration of the debt fund portfolios.
However, this amendment does help in reducing the magnitude of that impact compared to the earlier suggested 100 years of maturity without the gliding path. This also reduces the impact on existing debt fund investors where the fund has an investment in perpetual bonds.
Debt funds were mostly preferred by Institutional investors, but over the last few years, many retail investors have started looking at it as a good investment avenue where the risk is less compared to equities.
There are different types of debt funds that invest in different types of bonds offered by different institutions with different maturity period. It may be better to reduce the interest rate risk by considering a low to medium duration portfolio and reduce the credit risk by looking at the companies where the debt funds have invested.
If you are a risk-averse investor, you should prioritize safety first and then consider return at the time of investing in debt funds. When you invest in funds that have some exposure in these perpetual bonds, the quality of the institution offering these bonds have a significant role, but for all the reasons mentioned above, you must consider that allocation as risky as equities.
-- Harshad Chetanwala is the Co-Founder of MyWealthGrowth.com.
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