Perpetual Bonds: What Is Wrong with Them and How To Make Them Right
Perpetual bonds—what a wonderful way to raise money! Never have to repay and the bondholder enjoys no vote. And there is no income tax either, even though the money is permanently taken. Accountants may have conspired to show it as a liability, but I wonder where is the liability? The only liability is to pay a coupon or interest rate in perpetuity. How do you value that as a liability? There are specialists who claim to find out unique ways to value these ‘bonds’. I say, why do you call them bonds, when there is no repayment?
These bonds are issued by public sector banks (PSBs), private banks, private non-banking finance companies (NBFCs) and various other entities which I cannot figure out from the names. Many names are unknown. Not every entity is a listed one and known. And, recently, we had the case of the Reserve Bank of India (RBI) saying that the perpetual bonds issued by Yes Bank stand ‘extinguished’! RBI is the approver, creator and destroyer. Yes Bank lives on; but the bonds have died. And there was no repayment. What a wonderful instrument to be issued!
One would expect that RBI would be an expert at assessing which issuers will live forever. Or is it that they are saying that these companies are high-risk and, hence, we permit them to issue bonds with no repayment? It is all very confusing even to financial experts. Originally, they were perhaps designed to be issued by PSBs, which keep eroding their capital as soon as they lend and, when the money has gone, write-offs would mean new capital. With the market not giving too much value to PSB shares, there was a limit to dilution by the government. Thus, they invented these bonds. They were labelled as AT-1 (additional tier-1) bonds. 
Now, if this was the reason we allowed PSBs to issue these bonds, why allow the private sector? Well, we are a nation of crony capitalism and so we said: ‘why not’. So, now we have known, unknown, high credit-risk, junk credit, listed or unlisted, all having issued these wonderful papers. There are over 400 such bonds and, in my view, some of the issuers are high-risk issuers even for a 10-year paper. But then, as we can argue, since there is no repayment, why should it matter who the issuer is? And RBI’s action in ‘writing off’ some AT-1 bonds, clearly tells us that the interest payments are also not likely to be perpetual in nature. Clearly, this is an instrument that has not been thought through by the regulator.
I look at some of the names and shudder. And more worrying is the undue haste by institutional investors and in rushing headlong into this kind of an instrument. A circular by the Securities and Exchange Board of India (SEBI) on adopting a conservative valuation has led to the government of India panicking because they think PSBs will now be in trouble. A bank like Bank of Baroda has issued dozens of such bonds. The government is able to use this instrument instead of pumping in money in as capital. Clearly, this instrument is big trouble when it sucks in the savings of the average investor who trusts the institutional investor to be careful with his money. And, surely, the retail investor is not bothered about the ‘best’ return but really bothered about the loss of principal. Yes Bank, DHFL are two of the write-offs so far. Surely, there will be more. 
Valuation of perpetual bonds is tricky. In my view, it has absolutely nothing to do with the ‘face value’ or the ‘principal’ amount. All that the instrument promises is a fixed amount of money every year, so long as the company is around and in a position to make this payment. So, we have a fixed amount of inflows each year. I have to assume a ‘life’ for the company. Assuming it to be perpetual seems weird to me. Yes Bank and DHFL were supposed to be forever companies. If not, surely RBI would not have permitted them to issue these papers.
So, if I assume that one of the issuers is going to be around for 50 years, I will have to take the coupon payments for the 50 years and discount them at a rate that is higher than the long bond rate of the sovereign. This is only a possibility. Now, some bonds come with ‘call’ options. Which means that the issuer can choose to repay the bond in full. No, I am not joking. It is only an OPTION and not an OBLIGATION. So, the government will say, use these dates as the maturity dates and then value them. 
Why? If there is a ‘put’ option, I would probably agree for this. When there is no trigger with the holder to get the money on the ‘call’ date, it is pointless. 
This instrument is too complex for the average investor and, hence, allowing institutions to shovel retail savings (mutual fund, provident fund, pension) into these bonds is not a great idea. A Yes Bank or a DHFL knocked the bottom off some bonds. And we have this glorious Franklin Templeton saga before us. The best of intentions, when combined with lack of fiduciary responsibility that comes from investing ‘other people’s money’, leads to risk of a magnitude that can hurt only the investor and never the manager, who brazenly takes his fee for having put your money into such a paper! And when there is a write-off, he suffers no pain financially.
It is fine when perpetual bonds come from a sovereign ownership, with a guarantee that on the entity ceasing to exist or getting into cash-flow problems, the payouts will either continue or the bond repaid. The way it is structured now, is merely another speculative cash-flow with valuation that seems to be manufactured. 
I would be happy to see no public money going into such instruments. Let it be sold to risk-takers by specifying a very high minimum ticket size, say Rs50 lakh. And make sure that institutional pool of money that has retail contributions, does not touch this, unless it is a sovereign-guaranteed paper. If there is a sovereign guarantee, even a coupon linked to some inflation benchmark would make it a great paper for government provident fund. It could also be suitable for some trusts which need regular cash-flows.
If there were put options on these kinds of papers, one could perhaps consider investments in them, provided the institutional investor who holds it on the put day, is compelled by law to exercise the put option in the larger interests of the investors. We have seen what happens when some fund managers play with the issuers and fail to exercise the put options. 
Complex financial instruments should be kept away from any pool of money that has retail investors. That would be a confidence booster for investors. Yes, it is not beneficial to the corporate world and the bankers, brokers and fund managers. But the regulators must take the investors’ side on this.
6 months ago
Who can forget the US 64 saga!!!! what was supposed to be a scheme that was akin to sovereign risk and a scheme that would continue in perpetuity was wound up on terms that left retail investors poorer and with their dreams of wealth creation shattered.....the issue is that for the issuers there is no fear of the law and worse no concern for the retail for retail investors to exercise their own judgement before buying into tall promises.
6 months ago
I think you're barking up the wrong tree.

This is no different from investing in junk stock, except you seem to make an exception for it. Perpetual bonds are no different from futures and options (or a junk stock, like KF Airlines) - both have their idiosyncratic risk factors which have to be explained to retail investors (that's why fiduciaries exists).

Nobody is stopping financial institutions from creating a bond market (with put/call options). If you think perpetual bonds are dangerous, sell it! Or better yet, don't buy it! The only problem is we do not have a vibrant bond market which would otherwise make this happen. Fix the root problem - create a marketplace - make it easier to match buyers and sellers. Free market capitalism is all about liquidity. Too bad our bond markets have next to zero liquidity (although it's somewhat better today than few years back).

Perpetual bonds make complete sense for a certain investor (read: super HNIs, wealthy family offices, sovereign wealth funds, pension funds, both who have the risk appetite to indulge in risky instruments).

However, I agree with your point that there has to be a limit to which mutual funds can invest in risky instruments in order to protect retail investors (or create a debt MF scheme which specialises in risky bonds and label it as highly risky scheme on par with risky equity schemes).

I had no idea provident funds invested in AT1 bonds? Do you have data to back this up? This is news to me.

And crony capitalism? Where did that come from?
Replied to adityag comment 6 months ago
I agree, the problem is here >>

"Fix the root problem - create a marketplace - make it easier to match buyers and sellers. "
6 months ago
If RBI does their job properly, even retail investors would be able to benefit from these bonds, maybe some better quality bonds.

They must allow only those comapnies who are capable of paying it all back.

If they are limiting this to certain investors, it doesn't go well with RBI.

Either it needs to be allowed for all or for no one !
6 months ago
Retail investors are being taken for a ride and this time it is none other than the Govt./RBI that is doing it. Retail investors have all the risks while the issuer has none. It is a fraud on all investors and people should spread the word to desist from investing or if you have then, sell it on the secondary market at whatever price you get and save your principal.
6 months ago
This AT-1 bonds issue must be limited to institutional investors, where no retail investor's fund is used. Investing in these AT-1 bonds is extremely high risky and have all chances to become money sucked by black hole. Taking money from general public must be avoided even if the interest offered is double digit and tax-free. It is like Ralph Nadar book - "Unsafe at any speed".
6 months ago
I usually like all of your work, but this article is just garbage. We have Perp bonds because we are a nation of crony capitalists? You can't be serious...We have decently developed capital markets and these instruments would ordinarily be add to their efficiency.
We don't need 'your view' about pricing these instruments because it is there in any Finance 101 textbook. (You are correct not to consider principle repayment.) Perp bonds are as old as capital markets and are simply valued as the payment/discount rate. The risk of these instruments, the risk of collapse or wipe-out etc. is captured by the discount rate.

It is surprising to see a veteran such as you advocate for such a blunt 'ban' when other solutions exist. It is very simplistic to think that banning these instruments would boost confidence for investors. Maybe you also think banning 2-wheelers would make roads safer too.
Replied to AJ_AJ comment 6 months ago
You seem to be a disgruntled Banker with a Bank with high NPAs... Its seems your bank foundation of Basic capital requirement and then not paying investors back has become a normal thing....With SEBIs move though too quick, these bonds which steal money from public with an accomplice like RBI should be banned...
Replied to solomon.coutinho comment 6 months ago
Couldn't be further from the truth. I'm just a free market investor who likes well developed, 'complete' capital markets. Banning instruments is not the way to go. The problem is NOT the AT1 bonds, it lies elsewhere.
Kamal Garg
Replied to AJ_AJ comment 6 months ago
What is that "elsewhere"?
Kamal Garg
6 months ago
Absolutely bang on. Each and every word written in the article is right and deserve a praise.
RBI is an approver, creator and destroyer - and of course the 'regulator' also - very well said.
Much has been written in various forms by various analysts/academicians, etc and I think this is the most castigating article on the subject matter. And no body is bothered.
See the dithering views on Yes Bank AT-1 case and LVB AT case. So it means that even the regulator is not clear what is what and how to deal with that.
6 months ago
fully agree with the author. public money should be kept away from these bonds.
Rajanikant Panigrahi
6 months ago
absolutely right sir
6 months ago
RBI must revive the Yes bank bonds if Yes bank is living on. This is so wrong !
6 months ago
Very well written.
6 months ago
If there is a thriving market for such bonds then there would be a benchmark for valuation. However I wholly agree with you that it should be kept away from any pool of money with retail participation
6 months ago
What is a currency note? A perpetual bond with zero coupon and transferable by delivery.
Replied to sharmaorajesh comment 6 months ago
Currency notes have sovereign guarantee which these bonds lack. They are merely a sleight of hand of the mighty government
Replied to sharmaorajesh comment 6 months ago
Ok. Let's for a moment comoare these perpetual bonds to Currency notes as you say. But in that case are we sating that these companies, some like Yes Bank and DHFL, are allowed to create these perpetual currency notes for free ?

Nice article and very important points have been highlighted.
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