How new norms for perpetual bonds will impact investors

Perpetual bonds have been at the centre of attention as their exposure in the portfolio both directly and through mutual funds has raised several questions for investors.

The bad experience of investors in the Yes Bank case has led to regulators taking a closer look at these bonds and their valuations. The end result has been restricting the exposure of mutual funds to such bonds plus streamlining the way in which they are valued.

Here’s a detailed look at these bonds and the changes impacting them:

Perpetual bonds

Perpetual bonds are those bonds that do not have any maturity date. This is why they are called perpetual bonds because in theory they can go on forever. The issuer gets to use the money and in turn has to pay interest on these bonds. These are also traded in the secondary market. Additional Tier 1 bonds also called AT 1 bonds that are issued by banks are an example of such type of bonds.

Call option on these bonds

Even though these bonds are named perpetual bonds, there is a facility present which is known as the call option on these bonds. This means that the issuer of the bonds can call up the bonds for repayment on the dates that are mentioned in the conditions related to the bonds. This gives an exit option to the investors in terms of redemption of the bonds and the issuer can also redeem them if there is a big mismatch between the interest rate in the market and the rates at which they have been issued.

Write-off

These bonds of Yes Bank, which were AT-1 bonds, caused a crisis for investors because at the time of the restructuring of the bank it was decided to write off the value of these bonds. This meant that the value went to zero which made these bonds even riskier than equity investments. Considering the situation faced by investors at that point of time the Securities and Exchange Board of India has come up with guidelines for the valuation of the bonds and limits for mutual fund exposure in their schemes.

Further impact

The new guidelines are at the centre of another controversy due to the fact that the bonds were in the initial guidelines required to be valued as if they have a life of 100 years. This has now been staggered so till March 31, 2022 they have to be valued at a life of 10 years which will progressively go up to 20% and 30 % over the next 6 months. After March 31, 2023, they have to be valued at 100 years maturity.

The longer the maturity of the bond, the more volatile its price and hence this can have an impact on the riskiness of the mutual funds that hold these bonds. Mutual funds hold a large part of these outstanding bonds but with the restriction that a scheme cannot hold more than 10% of such bonds in its portfolio with not more than 5% from a single issuer, there is a clear attempt to reduce the risk related to these bonds. This is a positive thing for investors and it is important for them to understand this.

(The writer is founder, Moneyeduschool. Views expressed are personal)