Perpetual Bonds: Death Eaters of the Investment World
An explainer on how perpetual bonds are used to dupe retail investors.
I was happily sipping coffee and pondering on the pointlessness of life when this news hit –
“AT-1 bonds to be valued assuming a maturity of 100 years.”
I was delighted. For the retail investor, this was great news. A historic wrong in our bond markets was about to be righted. I also realized that this was something you, our reader, would want to understand deeper.
I started gathering material, going through pages after pages of how this instrument was being used. I had a hint of how the same was a way to dupe retail investors. But I did not understand the extent of it.
To give you a flavour of how bad this is, let me name some banks that used AT-1 bonds to raise money - Yes Bank, Andhra Bank, Lakshmi Vilas Bank. What’s common with these names? All of them refused to pay back their bondholders.
All investors who put their hard-earned money in these bonds lost it.
Why? How? What’s so weird about these AT-1 or “perpetual” bonds?
Sit back, and read on.
Infinity is a concept we come across only on paper. No one has seen it, lived it, and it’s just a mathematical construct. What we can’t measure, is infinite. Like love.
Now, in the world of Bonds, there’s this one very special bond – one that can live forever, one that does not require its issuer to pay back. I don’t know about your relationship, but this bond is meant to stay forever.
“But, isn’t this like equity? Where the company has no obligation to pay back the amount taken from you, ever? And only gives you the profits it earns on your money?”
Yes. Exactly! Perpetual bonds (“perps”) are bonds issued for eternity – they have no redemption period. They are the “Forever Loans.” And they feel exactly like equity.
Now, imagine someone asking you for a loan and saying they will return the money… never! Isn’t that so damned risky? What if they run away? What if they die?
Well, yes. Perpetual bonds are as risky as bonds can be. Sometimes, even riskier than equity.
“But then, why issue them? What purpose do they serve?”
They serve a very specific purpose.
To understand this, let’s take a step back and understand how the capital structure of banks looks like. Banks have the following sources of getting money:
Equity
Additional Tier – 1 or Tier 2 Bond (Perps)
Loans (regular bonds, debentures, etc)
Deposits from customers
Deposits are pure liabilities. It’s someone else’s money, and that person has kept the money to keep it safe. Hence, there are a lot of rules against the illegitimate use of these funds. This money is usually not messed around with (and is the cheapest source of funds for the bank).
Equity is the owners’ capital, and the profits that the company retains (does not distribute to shareholders). Owners, of course, take the max risk and are paid after everyone else is paid off.
A large chunk of a bank’s fund comes from loans. They issue bonds in the financial markets and take money from retail investors (directly) or from Mutual Funds acting on behalf of retail investors (indirectly).
Some of the banks did not know if they would be able to pay back people who gave them loans. Also, they couldn’t keep raising more equity, because that’s usually a costly process, and takes a long time. So, what was the middle ground? What to do when you want money forever, and still pay lower interest on it? You wave your magic finance wand and create something called the Additional Tier – 1 capital, fuelled by AT-1 bonds or perps.
Now, for a normal, sane person, this is how an investment in bonds looks like:
1. Give an amount (say Rs. 1L) on loan to someone
2. That someone pays (say 10%) interest every year on the same for (say) 5 years
3. And, they return the initial Rs. 1L after 5 years
Simple enough, right? You give Rs. 1L – you get a fixed return till the other person uses the money – you get the money back after the specified period.
Now, what happens in perps? You never get that Rs. 1L back. The bank takes the money from you and says that they are going to keep it forever. But, they promise to give you a certain fixed return as well, forever.
Sounds like an awesome deal?
It’s not. What investors fail to understand is that the banks who have asked to keep your money forever, may not live forever. They may die. They are not immortal.
And, that’s what happened with those who invested in AT-1 bonds, or perps, of Yes Bank, Andhra Bank, and Lakshmi Vilas Bank. The investors thought that they would be paid back the amount like other bondholders, but the entire sum was written off. A stroke of a pen and all your investments declared dead. All your savings gone poof!
“But – don’t people who invest in these risky perps know or are made aware of all this?”
Hahaa. Naaah. In fact, to sweeten the deal for retail investors, and make them invest in these bonds, there’s a “call option” that’s included.
“What’s that?”
A “call” option implies that the bank (issuer) has a right to buy the bonds from you (investor) after a fixed tenure. This tenure is usually 5-10 years.
“So basically, at the end of the period, the bank will be obliged to buy the bond back from us, essentially returning our money? But, this makes them safe – no?”
That’s where you got played! The banks have a right to buy, but no obligation. They can very well say “No” to exercise that option. Which they did in the case of Yes Bank. They were not “obligated” to pay the bondholders back, and hence, the amount was written off.
This 5-year assumed redemption kinda became a norm as most of the issuers (banks) exercised their call options, and gave the money back to bondholders. And so, mutual funds started valuing perps basis a 5 year fixed tenure. This made perps seem safer, and more attractive to investors. The price of perps did not reflect the risk that came with it.
And that’s why, SEBI, the messiah of the retail investor, butted in.
They have now asked for the valuation to be done basis a 100-year period. This will help the investors know what they are getting into, and price the instrument correctly. Situations like Yes Bank have taught SEBI a lesson. But the Mutual Fund bosses, along with the Ministry of Finance, are pushing SEBI to not implement this as it will have a drastic short term negative impact on their fund values.
Confused how the valuation of a bond will change if the tenure is 5 years vs. 100 years?
Let me explain this intuitively.
Heard this phrase: higher the risk, higher the return? Well, it’s again incomplete. Higher the risk, higher the expected return.
Logic is simple - the one taking more tension should be rewarded more.
Now, what would induce more tension? Giving a loan for 5 years, and getting the money back quickly, or giving a loan for 100 years?
Right. The 100 year one will be more stressful because we don’t know what will happen over the next 100 years - it is difficult to predict. Uncertain. Thus, as the tenure increases, an investor’s risk increases. As risk increases, their expectation of higher return increases.
Now, to get a higher return on something, what will you have to do? Buy it cheaper? Yes. Only when you buy cheaper, will your overall return be higher.
Hence, a 100-year bond with the same interest rate should sell cheaper than a 5-year bond. Right now, they are overpriced. SEBI’s move will make them rightly priced. Mutual Funds will have to book a loss. Hence, the drama.
But, SEBI has kinda given in, and said that they will implement it in a staggered way. Till FY-22, fund managers can pretend that the tenure is 10 years. Thereafter, it has to be increased to 100 years by FY-23.
A fair compromise.
We don’t know if the perps are forever, but we hope you now understand what AT-1 bonds are, and how they are used to dupe retail investors (mostly via mutual funds). Makes us question, once again, Kya Mutual Funds Sahi Hai?
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By Shantanu Jain, on a mission to make India financially literate.