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.