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Perpetual debt in favour, but yields may fall

Perpetual debt in favour, but yields may fall
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First Published: Mon, Jul 30 2007. 05 15 PM IST
Updated: Mon, Jul 30 2007. 05 15 PM IST
Mumbai: Investors are stepping up buying of Indian perpetual debt, a form of corporate bond which has no maturity and pays above normal debt, because interest rates are seen close to the top of the cycle, merchant bankers said.
But yields on these bonds may come down sharply if the central bank holds interest rates steady on Tuesday, as expected, and takes no steps to drain yield-dampening cash from the system.
Perpetual bonds were introduced in 2006 to let banks raise funds to meet credit demand and fulfil Basel II capital adequacy rules without diluting their equity base.
They do not mature, but banks have a call option after 10 years to retire the bonds. If they don’t exercise the option, the interest payment rises by a maximum of one percentage point.
Their draw is the high yield at a time when many believe the central bank is done tightening for now. The banking sector too is expected grow strongly due to robust loan growth.
“It doesn’t get better than this,” said one merchant banker.
“If you have a view that interest rates have peaked, then the longer the bond, the better the yield pick-up.”
Perpetual bonds pay 10-11%, 50-70 basis points above yields on AAA-rated 10-year bonds issued by banks. The sovereign equivalent currently yields about 7.84%.
Issues have surged after a gap of half a year and merchant bankers estimate Rs 15 billion ($370 million) worth of perpetual bonds will hit the market over the next two months.
State Bank of India, the country’s biggest bank, is expected to unveil a Rs 10-billion issue this week.
The merchant banker said SBI was trying to place its bond at 9.90%, lower than its competitors which have sold at about 10.5%. The lower coupon indicates rising demand.
“Retirement funds still are the big investors and traders are latching on to this because sentiment is bullish on rates,” one arranger said.
“If the RBI comes out very hawkish, or if supplies continue to be huge, then demand may slacken,” he said.
Since mid-June, Punjab National Bank has made a Rs5-billion issue at 10.40%, Bank of India, a Rs4-billion issue at 10.55% and Bank of Maharashtra raised Rs2.25 billion at 10.65%.
Spreads Buckle
Banks may raise an equivalent of up to 15% of equity via perpetual debt and the government says they need more than Rs500 billion to meet capital adequacy rules in 2007-08.
Underwriters sold about Rs40 billion of these bonds in 2006, before the central bank started tightening the monetary screw. It raised rates five times between June 2006 and March 2007, pushing up borrowing costs for issuers.
But with inflation now below 5%, analysts see the central bank holding rates steady on Tuesday, at least for a few months. Furthermore, intervention to keep the rising rupee down has injected large doses of cash into the banking system.
“With liquidity so abundant, spreads have collapsed and at around these levels such bonds offer juicy yields,” said Nirav Dalal, director of debt capital markets at Yes Bank.
The spread between the benchmark 5-year AAA corporate bond and the 5-year government bond has compressed by 44 basis points in the past two weeks. The yield on the benchmark 10-year corporate bond has fallen by 70 basis points in the past month.
Perpetual bonds typically attract pension funds, but bankers say banks and mutual funds have been snapping them up.
They carry some risks. If a borrower’s capital adequacy ratio falls below 9%, it does not have to pay interest on the bonds, and pricing them in the secondary market is difficult.
“Now most investors price them taking it as a 10-year bond,” said a merchant banker.
“For existing holders, if they want to offload their bonds, the illiquidity premium they might have to pay can be huge.”
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First Published: Mon, Jul 30 2007. 05 15 PM IST