However, in many cases, investors are not warned of the risks involved. Some of the perpetual bonds (such as AT1 bonds) are explicitly issued as “risk absorbing" instruments and are subject to write-down if the bank’s capital falls below predefined thresholds. Here are the risks of investing in this product.
Unlike FDs (which have a guarantee of up to ₹5 lakh under deposit insurance), perpetual bonds have no guarantee even though they are issued by banks. These bonds are issued under Basel norms to shore up the capital of banks. If a bank’s capital dips below certain thresholds due to bad assets, they can skip interest payments on these bonds and even write-down their value. This makes them a lot closer in nature to equity than debt.
Bond investors are not treated with the same care as FD investors, as the example of Yes Bank shows. In March 2020, when the bank faced a crisis, it chose to write down the entire value of some of its perpetual bonds (called AT1), amounting to about ₹8,700 crore. The bank’s FD investors were not subject to losses although temporary restrictions were placed on withdrawals. The AT1 write-down was done while leaving the bank’s share capital intact, in effect placing perpetual bond holders below even shareholders.
Nishith Baldevdas, a Chennai-based Sebi-registered investment adviser pointed out that these bonds have concentration risk due to their large ticket size (minimum ₹10 lakh). Investing the same amount in a debt mutual fund can get you access to a portfolio of 20-50 different kinds of debt papers, thereby reducing risk.
Repayment date risk
Perpetual bonds are often marketed as having a five- or 10-year tenor. In reality, these marketing pitches hide the fact that the maturity of the bond is simply the bank’s right to repay the principal value. The bank is not bound to pay back the investors in these bonds. It can choose to not repay the principal and simply keep paying the interest.
In the past, banks have chosen to exercise call options to avoid market panics. Andhra Bank, a nationalized bank, tried to skip repayment in December 2019, but reversed its position within a few days due to pressure from the markets. However, as the case of Yes Bank shows, in times of distress banks can not only skip repayment, but also write down the bonds.
It may be noted that banks are under stress due to the Covid-19 crisis. Around one-third of the loan books of major Indian banks are under moratorium, a media presentation by Motilal Oswal AMC on 13 May 2020 showed. Moratorium is a facility given by the Reserve Bank of India (RBI) under which a borrower can halt repayments on loans until June-end. However, there is no guarantee that the economy will revive after June. An economy in recession can convert a borrower in temporary distress into a borrower who is insolvent. Many of these loans under moratorium can become non-performing assets (NPAs) and wipe out perpetual bonds.
If you need money for your financial goals or an emergency, you will have to sell your perpetual bonds in the market. However, the Indian corporate bond market is extremely thin and you may not get any buyers. This lack of liquidity was one of the factors that forced Franklin Templeton Mutual Fund to wind up six of its debt schemes on 23 April.
In comparison, most bank FDs can be redeemed at any time after paying an interest rate penalty (usually 1%). Even mutual funds are more liquid, despite the Franklin Templeton incident. They have exit loads and you can end up taking a loss if you exit at a bad time. However, in an open-ended fund, you will get your redemption proceeds at the prevailing net asset value (NAV).
This is the risk of inflation eating away at your returns. For example, if the bond yield is 8% and inflation is 8.5%, you will actually end up losing money in the bond. This effect is strongest in longest tenor bonds like perpetual bonds (which have indefinite tenor).
In shorter-dated bonds, your money comes back faster and you can always reinvest it in bonds with higher yields or in assets like equity and gold. These assets, although volatile, tend to give better returns than bonds when inflation is up.
Interest rate risk
Higher interest rates often follow a rise in inflation. When interest rates rise, bond prices fall and vice-versa. The effect is particularly strong for long-dated bonds such as perpetual bonds. A drop in the bond’s price does not hurt if you intend to hold it to maturity. However, if you want to sell it before that, you will get a lower price.
As RBI cuts policy rates and banks reduce their FD rates, the temptation to invest in these bonds will be strong. However, you should think carefully about all the associated risks before investing your hard-earned money in them. “In debt, you should prioritize safety and liquidity and then look at returns," said Baldevdas. “A slightly higher yield or interest rate can mean risking your entire capital," he added.
Speak to a financial advisor if you are unable to understand all the risks involved.