“There is a basic problem with perpetual bonds or perps; it is a finance 101 issue” says a top banker, explaining the controversy triggered last week over how these bonds have been valued since inception.
On 10th March, the Securities and Exchange Board of India (SEBI) had taken another step forward in its belated attempt to protect investors after nearly Rs10,000 crore of bonds were wiped out, when the Reserve Bank of India (RBI) and State Bank of India (SBI) wrote off Rs8,415 crore of AT-1 (Additional Tier-1) bonds issued by Yes Bank as part of the bailout process, last year. Similar action was triggered in Lakshmi Vilas Bank (LVB) and Dewan Housing Finance Ltd (DHFL) bailouts, exposing several warts in the instrument. Even Infrastructure Leasing & Financial Services had issued perps.
Under global banking norms (Basel-III), banks and finance companies are permitted to issue AT-1 and Additional Tier-2 (AT-2) bonds, to shore up their equity capital. These bonds come under the generic nomenclature of ‘perpetual bonds’. So, they are essentially quasi-equity products, or worse; they were called bonds, and actively mis-sold as safe investments to retail investors, until the regulator finally woke up last year.
As our columnist R Balakrishnan wrote on 16th March (Read: Perpetual Bonds: What Is Wrong with Them and How To Make Them Right), it is a misnomer to call these bonds, since they are ‘perpetual’, which means that there is no obligation to repay and only interest to service. In fact, there is no obligation to service the interest either, in times of financial difficulty. This means that the bonds are actually riskier than equity, as investors of failed institutions have found to their chagrin.
As the banker quoted above says, this risky instrument is further ‘sweetened for the issuer, not the investor’ with a one-way call option after five years. This means, if interest rates go down, the issuer can exercise the call and buy back the bond; but if interest rates rise, the bonds can remain in perpetuity. There is no put option available to investors. The valuation of such bonds is complex; but our expert valuers, the notorious credit rating agencies, have been valuing perps as five-year paper based on the ‘call’ dates of the bonds. This gave perps a higher valuation than they deserved.
Such questionable ratings allowed mutual fund (MF) managers to stuff debt scheme portfolios with perpetual bonds in order to show a higher return. Although valuing perps is admittedly difficult, it is not as though the industry was unaware of risks. Bond market expert Rajendra Gill points out that it is simplistic and disingenuous for MFs to argue that “so far, all perps have been called by issuers, which is why it is fair to value them on yield-to-call basis,” especially when they have been written off in several cases. He also says, “As per my recollection, these bonds, globally, are valued not on a yield-to-call basis but on a yield-to-worst basis, which models the scenarios in which the issuer will not call the bond.”
Shockingly, some fund houses even have perps in their short-term schemes based on the five-year call dates. But SEBI, which is still busy tinkering with regulations, hasn’t even got around to questioning the risk assessment, compliance and failure to meet fiduciary obligation by such schemes. Instead, the MF industry, as a group, is lobbying for a rollback of rules.
Importantly, while SEBI and RBI were sleeping at the wheel, the Insurance Regulatory and Development Authority of India (IRDAI) was awake to the issue. “Do you know that IRDAI does not allow insurance companies to buy perps at all, and, if they do, they are considered part of equity,” says the banker quoted earlier. Does it mean that SEBI and RBI were deliberately quiet because the MF industry influences regulation? By the time SEBI started fixing regulatory gaps, Rs85,000 crore of perpetual bonds had been issued. Fund houses were big shoppers with Rs35,000 crore in their portfolios. As R Balakrishnan points out, there are nearly 400 issues of perpetual bonds in the market and some issuers are downright dodgy.
SEBI then announced new rules for issuance, listing and trading of perpetual instruments and protected retail investors by mandating a minimum trading lot and allotment of Rs1 crore. This still did not protect investors who trusted the “mutual fund sahi hai” slogan, because fund managers ignored valuation issues.
On 10th March, SEBI’s new circular placed strict caps and restrictions on investment in perpetual bonds effective 1st April, with a grandfathering clause for existing schemes. It fixed the faulty valuation by mandating that the maturity of bonds should be calculated at 100 years.
The finance ministry responded to this long overdue regulation with an astonishing ‘request’ to roll-back the ‘disruptive’ clause on valuation, because it would negatively impact the ability of banks to raise capital through these quasi-equity bonds. The ministry said there was no benchmark to value a 100-year maturity bond and SEBI’s move would dry up the market for these bonds.
Does this mean that the ministry supports faulty valuation of bonds and the brazen mis-selling that inflicted losses on investors? Does it have no fiduciary responsibility to investors? Or is capital raising by public sector banks (PSBs) justification enough not to correct a wrong? Meanwhile, the banking regulator, whose action in Yes Bank triggered the clean-up, continues to remain silent.
What will SEBI do next? Rolling back the circular or even deferring the new investment caps and valuation norms from 1st April to 1st October could prove embarrassing for SEBI and be seen as anti-investor, given that Yes Bank investors are in court over the losses they suffered. So, the effort by powerful stakeholders, such as MFs, PSBs and their owner, the finance ministry, is to build consensus for a partial rollback.
One suggestion is to introduce the new valuation in a phased manner, or ‘grandfather’ the mistakes in valuation. One editorial pushes for a solution that “neither damage(s) the prospects of bonds with special features nor leaves the prestige of the parties in tatters.” Why do we need to protect the prestige of those who failed to protect investors adequately?
Another suggestion which is perhaps under consideration is that, although future bonds will have to be valued at a 100-year maturity, the existing ones can be valued at a 40-year maturity—the longest dated government securities issued. Mr Gill points out that the valuation of these bonds must be on a ‘yield-to-worst’ basis.
The Association of Mutual Funds of India (AMFI), while paying lip service to correcting the ‘mispricing of risk’, claims that there could be panic selling in the secondary market, which is “reasonably active with regular trades in large and higher rated issuances.” Bankers say there is no liquidity for bonds and little scope for a market to develop in the near term because of the huge supply overhang. “Also, with interest rates moving up, the bonds will become truly perpetual as issuers are unlikely to call them if yields get closer to issued yield as they approach the call date,” says a source.
What the regulator decides will show how seriously it takes its fiduciary duty of investor protection.