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Risks of investing in perpetual bonds

Risks of investing in perpetual bonds
Retail investors who had invested in Perpetual Bonds issued by Yes Bank, under the impression that these bonds were similar to fixed deposits, are now facing the likelihood of a total loss of their investment. The bank is estimated to have sold Rs 10,000 crore worth of AT1 bonds which are perpetual bonds yielding annual interest. Bulk of these bonds are held by institutions, including mutual funds, but some are also held by retail investors.

A critical aspect of such bonds is that they have no maturity date and the only way an investor can get his/her investment back is by selling them in the secondary debt market unless the issuer calls the bonds back i.e. redeems them. When the issuer sinks, such as Yes Bank, it is unlikely to redeem the bonds on its own (typically there is no legal obligation to do so) and finding buyers in the secondary market for these becomes next to impossible for investors.

While the government has assured depositors that they will not be penalised, RBI’s draft plan for the bank envisages a complete write-off of the AT1 bonds. The final plan is still awaited but if there is a write-off, investors in debt schemes of mutual funds, which bought these bonds, will also face losses due to fall in NAVs of their units.

AT1 bonds are issued to raise AT 1 or Additional Tier 1 capital. In a rush to meet the Basel III norms on AT1 capital, banks and non-banking finance companies (NBFC) hit the market with a large number of AT1 bonds or perpetual bonds in the second half of last year. As liquidity was an issue and the NBFC crisis had scared investors, the entities were forced to announce higher coupon rates at that time. Consequently, the yield being offered by these bonds was significantly higher than fixed deposit rates which lured some retail investors who were unaware of the risks.

What are the risks associated with perpetual bonds?

Unsecured

Though the bonds are issued by large corporates, investors should understand the implications of the company going into liquidation. Perpetual bonds are subordinate to senior bonds in the event of liquidation, say financial experts. For claiming final receipt, the status of perpetual bonds is just above that of preference shares. This means perpetual bond investors will be paid after all other claimants like depositors, other bond holders, etc are paid. Preference and equity shareholders will be the ones to be paid after that, experts explain.

No profit, no interest

Unlike normal bonds, where interest has to be paid irrespective of whether the issuer is making profits or loss, the rules are different for perpetual bonds. If there are no free reserves to dip into, there won’t be interest payment in case of loss in a year by the issuer, according to experts. Free reserves are created out of profits from previous years.

Non cumulative

Another restrictive feature is tier 1 perpetual bonds are non cumulative. This means that interest that does not get paid in a year, due to the company making a loss, does not cumulate. Therefore, bond holders are not eligible to get the same in later years even if the company makes a profit.

Call option

Further, perpetual bonds normally come with a call option—the issuers have the right to call (redeem) these bonds early. This means these institutions will call them back (redeem them) if the interest rates go down from current levels, but will keep them alive if the interest rates go up. In other words, these bonds are perpetual only for the investor and not for the issuer. Yield calculation is also different. Due to the call option, investors should calculate yield to call (YTC) instead of yield to maturity (YTM) for these bonds, say experts.

Low liquidity

Unlike other bonds that have a maturity date—when the issuer returns the principal, liquidity is critical for perpetual bonds because selling in the secondary market is the only option available. However, liquidity is low and the bid-ask spread is high.

Company-specific risks

In addition to the broader risks, investors should note that there will also be company-specific risks. Thus, investors should first look at their own risk appetite and then consider only perpetual bonds issued by very healthy institutions and after evaluating the risks associated with these bonds. Before buying bonds, investors should do a detailed cash flow analysis and make sure they are getting only into strong institutions. However, the yield available from high quality corporates is normally much lower compared to risky ones. For example, in October last year the YTC of HDFC Bank perpetual bonds was only 8.27% compared to the YTC of 18% from Yes Bank.

Since doing a detailed analysis can be difficult for retail investors, in Europe there are restrictions on selling such bonds to retail investors. If an investor does not have the skill to evaluate company specific risk it is better than he/she avoids such bonds, say experts.

Source



This post first appeared on TechnoCodex, please read the originial post: here

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Risks of investing in perpetual bonds

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