7 Mar 2020

Perpetual Bonds are the Riskiest Instruments Available, Investors Beware

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Mutual Funds and Insurance Companies put together have lost close to Rs 90 billion on the back of RBI writing off the AT1 bonds (perpetual bonds) of Yes Bank under the reconstruction scheme.

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Arjun Parthasarathy

Mutual Funds and Insurance Companies put together have lost close to Rs 90 billion on the back of RBI writing off the AT1 bonds (perpetual bonds) of Yes Bank under the reconstruction scheme.

The write down of the perpetual bonds or perps as termed in the market signifies the risk of these instruments, as the holders of the bonds absorb the full losses suffered by the bank. Apart from the loss provisions of these bonds, the risk of these bonds include interest rate risk, liquidity risk and also risk of the option (call).

In India, perps are finding favour with retail investors as they are sold as a risk free high yield instruments. Perps are priced at higher yields purely because of the risk they carry and Yes Bank perps have brought out the full risk in the perps.

Institutional investors, who claim to have better knowledge of these instruments have lost money in Yes Bank and also by premature call option exercise by PSU Banls. Retail investors have zero knowledge  of these bonds and yet still invest in them, as they are pushed by intermediaries and advisors as higher yield bonds with no risk.

Perps will now face huge lack of liquidity as institutions will avoid them completely and retail investors could face high risk of default if more banks go down the Yes Bank path.

RBI Notification on Yes Bank Reconstruction Scheme

On the 5th of March 2020, after placing Yes Bank bank on Moratorium, RBI announces a scheme of reconstruction for Yes Bank, as lack of liquidity, capital and the absence of any credible plan for infusion of capital led to potential defaults by the bank on its debt obligations.

Unless otherwise expressly provided in the reconstruction scheme, all contracts, deeds, bonds, agreements, powers of attorney, grants of legal representation and other instruments of any nature, subsisting or having effect immediately before the appointed date, to be effective to the extent and in the same manner, as was applicable before the Scheme and same is applicable to all the deposits with and liabilities of the Reconstructed bank, the rights, liabilities and obligations of its creditors.

But the instruments qualifying as Additional Tier 1 capital, issued by Yes Bank under Basel III framework, to be stand written down permanently, in full.

Bank’s Additional Tier I and Tier 2 bonds have credit rating of D, As of 5th March 2020,  as per ICRA, Additional Tier I bonds outstanding was Rs 108 billion.

Loss Absorption Features of AT1 Bonds

Basel III non-common equity elements which is included in Tier 1 capital can absorb losses provided the bank remains a going concern. AT 1 bonds principal loss absorption can be done through either conversion into common shares or ( write-down mechanism, which allocates losses to the instrument at an objective pre-specified trigger point.

The write-down can reduce the claim of the instrument in liquidation, reduce the amount re-paid when a call is exercised, partially or fully reduce coupon/dividend payments on the instrument.

The pre-specified trigger for loss absorption through conversion/write-down of the Additional Tier 1 instrument should satisfy Common Equity Tier 1 capital of 6.125% of RWAs.

The conversion or write-down mechanism (temporary or permanent) which allocates losses to the Additional Tier 1 instrument (AT1) instruments can generate Common Equity Tier 1 (CET1) under applicable Indian Accounting Standards.

What is the treatment of AT1 Instruments in the event of  Winding-Up, Amalgamation, Acquisition, Re-Constitution of the Bank

If a bank goes into liquidation before the AT1 instruments have been written-down or converted, these instruments will absorb losses.

If a bank is amalgamated with any other bank before the AT1 instruments have been written-down or converted, these instruments to become part of the corresponding categories of regulatory capital of the new bank emerging after the merger.

If a bank is amalgamated with any other bank after the AT1 instruments have been written-down temporarily, the amalgamated entity can write-up these instruments as per its discretion, if written-down permanently, these cannot be written up by the amalgamated entity.

All non-common equity Tier 1 and Tier 2 capital instruments issued by banks in India must have a provision that requires such instruments, to either be written off or converted into common equity upon the occurrence of the trigger event, called the ‘Point of Non-Viability (PONV) Trigger’.RBI decides PONV trigger event criteria.

Bank also may repurchase or buy-back or redeem the Perpetual Debt Instruments (PDIs) with prior approval of RBI only if the instrument is replaced with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank.

Risk in Perps

Perpetual bonds by nature are risky as they are callable and have many covenants that can hurt bond investors if banks loan books turn bad. Investors have already had experience of perpetual bonds being called prematurely, giving them capital loss if they had bought at a premium.

Many bonds are trading at discount to face value, again giving notional capital loss to investors who have bought the bonds at higher price and are holding the bonds or realized capital loss to those who have sold the bonds.

Perpetual bonds carry many risks including interest rate risk, credit risk, liquidity risk and pricing risk, Non institutional investors believe that by holding the bonds until they are called will given them the necessary yield they are looking for and also negate all risks, especially credit risk.

The question of credit risk throws up the perceived implicit support of RBI and the government, where banks are not allowed to fail. This can be both right and wrong. Weak government owned banks are receiving capital support from the government or are being merged  with bigger banks eg. Dena Bank, Vijaya Bank with BOB and SBI subsidiaries being merged with itself.

On the private banks, ICICI Bank and HDFC Bank have been classified as too big to fail but will RBI allow other banks to fail? Until now it has not happened but it can always happen, as there is nothing that stops the RBI to let banks fail if they sink under bad loans. No bank has any  guarantee from RBI or government though government banks have implicit guarantee.

Until now, no private bank has failed, RBI ensured Global Trust Bank was merged and not allowed to fail but now with many banks facing bad loan issues, it may be difficult for RBI to protect all banks.

The risk levels of perpetual bonds are high and unless investors can evaluate the risk, it is best to stay off such bonds especially the weak banks.

Perpetual Bonds – What does it mean to Bond Holders?

Basel III Tier 1 and Tier 2 bonds are more riskier in nature than Basel II Tier 1 and Tier 2 bonds.Hence any downgrade will impact Basel III Tier 1 and Tier 2 bonds significantly.In case of PSU banks, Government strong support as major share holder is the only protection for bond holders.


Basel Committee on Bank Supervision (BCBS) has certain agreements of its own and these are known as Basel Accord. India is also included in this committee. Basel Accord ensures that all the financial institutions such as banks and NBFCs have enough capital to absorb unexpected losses and to maintain reserves or obligation.

There are three main kinds of guidelines given by BCBS known as Basel-I, Basel-II and Basel-III. While Basel-I focuses only on credit risk. Basel-II concentrates on risk management, capital inadequacy and disclosure requirements.

In order to strengthen the resilience of the banking sector to potential future shocks, together with ensuring adequate liquidity in the banking system, the Basel Committee on Banking Supervision issued the Basel III proposals in 2010.Basically Basel III is continuation of Basel I and Basel II.

Basel III measures mainly focus on improvement of the banking sector’s ability to absorb shocks arising from financial and economic stress, improve risk management and governance, and strengthen banks’ transparency and disclosures.

Basel III in India

During fiscal 2013, RBI issued the final guidelines on the Basel III capital regulations. The implementation of this framework had commenced from April 1, 2013 in a phased manner through till March 31, 2019.RBI financial stability report 2012 mentions Indian banks will require an additional capital of Rs.5 trillion to implement Basel III norms, including Rs 3.25 trillion as non-equity capital and Rs 1.75 trillion in the form of equity capital in the next five years. According to Basel III framework the LCR (Liquidity coverage ratio) requirement would be minimum 60% for the calendar year 2015 with effect from January 1, 2015 and rise in equal steps to reach 100% on January 1, 2019. The liquidity coverage ratio (LCR) is the percentage of highly liquid assets (treasury bank, cash etc.) a bank should hold in order to meet its short-term obligations.

The basic pillar structure of Basel III:

Pillar 1: Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) Maintaining capital calculated through credit, market and operational risk areas.

Pillar 2: Regulating tools and frameworks for dealing with peripheral risks that banks face.

Pillar 3: Increasing the disclosures that banks must provide to increase the transparency of banks.

As per the Basel III norms, banks have to maintain Tier-one capital at seven percent of risk weighted assets (RWA), Tier 2 at 2 percent of RWA and have to maintain their total capital ratio at nine percent.

Tier I Capital

Tier I is regulatory capital. It consists mainly of share capital and disclosed reserves. Tier I components are deemed to be of the highest quality because they are fully available to cover losses Hence it is also termed as core capital. Basel-III Tier-I non-equity capital comprises preference shares and perpetual bonds.Tier I capital has two components, Common Equity Tier I and Additional Tier I.It is a going-concern capital that means banks can absorb losses without triggering bankruptcy.

Under Basel III-compliant Tier I instruments, Banks can decide on cancelling of distribution of coupon payments. Coupon can also can be paid out of eligible reserves if current year profits are not sufficient or in case of loss, provided the bank meets all other regulatory capital requirements.

Under Basel II-compliant Tier I instruments Banks are not liable to make interest payments on these instruments if capital adequacy ratio falls below minimum  requirement.If bank reports a loss,RBI permission is required for coupon payment

Non-equity Regulatory Capital Instruments – Additional Tier 1

One of the criteria for Additional Tier 1 capital instruments issued by banks requires that these instruments should have principal loss absorption at an objective pre specified trigger (6.125% of risk weighted assets,capital adequacy ratio).Banks can issue these instruments with the principal loss absorption through either (i) conversion into common shares or (ii) write-down mechanism (temporary or permanent) which allocates losses to the instruments.AT-1 bonds are rated three notches lower than the bank’s corporate credit rating.

The call option on Additional Tier 1 Instrument is permissible at the initiative of the issuer after at least five years. Banks can issue Additional Tier 1 capital instruments to the retail investors, subject to the approval of their Board. However, with a view to enhancing investor education and awareness of risk characteristic of Additional Tier 1 Instruments, banks should also adhere to the investor protection requirements. Coupon may be paid out of current year profits. However, if current year profits are not sufficient and payment of coupon is likely to result in losses during the current year, the balance amount of coupon may be paid out of revenue reserves ( revenue reserves which are not created for specific purposes by a bank) and  credit balance in profit and loss account.

Pension fund regulator PFRDA also permitted pension funds to invest in Basel III compliant Tier I bonds of banks to help Pension Funds to diversify their investments. Indian banks have to comply with Basel III capital norms by March 2019, including maintaining a minimum capital adequacy ratio of 11.5 percent. To meet Basel III norms, Indian banks will require an additional Rs 5 trillion of capital by 2019.

Tier II Capital

It is the components of regulatory capital.It consists of certain reserves and certain types of subordinated debt. Tier II items are set as regulatory capital to the extent that they can be used to absorb losses arising from a bank’s activities. Tier II’s capital loss absorption capacity is lower than that of Tier I capital.It is gone-concern capital that means it can absorb losses only in a situation of liquidation of the bank

Basel III-compliant Tier II capital instruments have additional features such as point of non-viability PONV trigger,which may result in loss of principal to the investor.

Prompt Corrective Action (PCA) Framework for Banks 

Capital, asset quality and profitability are tracked. Capital is tracked through CRAR and Common Equity Tier I ratio. Asset quality is tracked through Net NPA ratio and profitability is tracked through Return on Assets. Breach of any risk threshold can result in invocation of PCA.

Breach of Risk Threshold 3 of CET-1 by a bank would identify a bank as a likely candidate for resolution through tools like amalgamation, reconstruction, winding up, etc.

Perpetual Bonds

Perpetual bonds are seen as good investments during low rate scenario as they carry higher yields and provide high capital appreciation when yields fall.They are flavour of the day investments and as long the investor knows when to stop buying or exit the bonds, the investments will do well.

Banks issuing perpetual bonds carry high credit risk if banks capital adequacy goes below regulatory norms as banks then do not have to service bond holders through interest payments as the bonds get converted to equity.

Perpetual bonds also carry interest rate and liquidity risk as at times when interest rates start to rise, yields rise and bonds turn illiquid as markets do not buy into option carrying bonds given pricing anamolies.

Fixed income securities or bonds are instruments which have a cash flow according to a predetermined rate of interest, paid according to a predetermined schedule.

Usually most of the bonds have a definite maturity period but if a bond has no maturity date it is known as a perpetual bond. Perpetual bond has cash flows to perpetuity; issuers pay coupons on it forever,also issuer don’t have to redeem the principal unless the bond has a call or a put option.

Advantage to an Issuer

Perpetual bonds issued by fiscally challenged government gives the advantage of raising money without ever needing to pay back. Corporates issue them as they just need to pay the interest which is tax deductible expense and the principle is never paid unless it has a call or a put option.

Advantage to an Investor

These bonds offer relatively higher coupon rates than normal bonds as they don’t have a maturity. Investor may  prefer these bonds because they offer steady, predictable source of income over a considerable long period of time.

Investing in these bonds during falling interest rate scenario is beneficial as in terms of better yield and capital appreciation.

Risk associated with Perpetual Bonds

Perpetuity keeps investor exposed to credit risk for a longer period of time. Bond issuers such as governments, PSUs and private corporations, can face financial trouble or default due to economic downturn. It also exposes the investor to liquidity risk as they cannot redeem them before the call option or put option.

The bonds too are not priced correctly if there are no vibrant yield curves to price put or call options. By default in India they are priced to call, which is not the right way to price the bonds.

In India banks and other financial sector companies issue perpetual bonds. Banks require the capital to meet their Additional Tier-1 capital needs as per Basel-III guidelines. Other PSU banks such as United Bank, IDBI, Canara Bank and IOB have raised funds through perpetual bonds. Other financial sector companies like Capital First, Cholamandalam, Tata Capital and DHFL have also issued these bonds.

To implement Basel III Capital Regulations, banks need to improve and strengthen their capital plan so they can issue perpetual debt instrument (PDI) as additional Tier 1 instruments,As per RBI these instruments will be subjected to a lock-in clause in terms of which the issuing bank is not to liable to pay interest, if the bank’s CRAR (Capital to Risk (Weighted) Assets Ratio) is below the minimum regulatory requirement prescribed by RBI,the impact of such payment results in bank’s capital to risk assets ratio (CRAR) falling below or remaining below the minimum regulatory requirement prescribed by RBI;However, banks can pay interest with the prior approval of RBI when the impact of such payment may result in net loss or increase the net loss, provided the CRAR remains above the regulatory norm.

Predominantly long term investors such as provident funds or insurance companies are investors in these bonds. Individual investors can also invest in them. Tax need to paid on interest income generated from perpetual bonds as per investor’s tax bracket.

How to value a Perpetual bond

Consider a perpetual bond with a 10% annual coupon and yield 8%, then price is calculated as

Price = Interest payment/yield=10/0.08=125

If bond has call or put option then its price is calculated to put or call. Ideally the option pricing will determine the value of the bond.



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