When Immortal Bonds become Mortal

Everybody’s worried about SEBI’s new perpetual bond norms. Unfortunately, if you aren’t intimately familiar with these complicated instruments, all this might sound like woo-woo. So in today’s Finshots, we provide an oversimplified account of the whole story.

And to make sure we leave no stone unturned, we will take it from the absolute top.

The Story

The Mutual Fund industry operates on a simple premise. And you could summarize it like this —“Regular investors have little know-how about the complexities inherent in the stock market. Therefore a better approach is to let experienced fund managers take care of business for you.”

And while there are many ways professionals can choose to manage your money, the most popular avenue is to create a mutual fund. This way companies can take your money, divert it to a common pool of funds —  mobilized from other people like you and invest this massive corpus in handpicked stocks to offer you outsized returns. All this for a small fee.

It seems like a win-win for everyone involved. But not everybody wants a piece of the Indian stock market and not everybody wants to experience this wild crazy trip. The ups and downs can be too much. It’s never a good feeling to hear that your fund is down 10% because the stock markets continue to tumble. So for the faint-hearted, they offer another alternative — a debt mutual fund.

This time they’ll use your money to lend to corporates and governments, instead of buying stocks from select companies. In return, the corporate will promise to pay the fund house the entire principal (within a specified time frame) and a fixed sum on top. The contract agreement is called a bond. The time frame — Maturity Period. And the fixed return on top is called the yield.

That’s the basics covered.

Anyway, if you were following our explanation so far, you should already see how these debt mutual funds might suit some investors. Unlike equity mutual funds, where the fund house is exposed to the swings of the market, debt mutual funds offer more consistent returns. Ergo, once a fund house invests in a bond, the corporate is liable to pay back the principal and the yield, in full, failing which the fund house can drag the corporate to bankruptcy court. So most corporates are likely to honour their obligation.

And at this point, we can safely introduce the star cast of this story — Perpetuals and AT-1 Bonds.

Perpetual bonds don’t have a fixed maturity. So there’s no obligation for the borrower to pay back the principal and that extra yield on top, ever. But this poses an interesting question. Why are perpetuals worth anything if the borrower isn’t obligated to return the money? It’s a nice point. But alas, there’s a rather simple answer — Perpetuals might not offer you the principal, but they do offer periodic interest. THIS is what gives them value.

And the AT-1 bond (central to this story) is a perpetual. So let’s start looking at this bad boy.

For starters, banks issue these bonds in a bid to raise money and cushion their coffers. It’s to make sure these institutions have enough cash to stave off a crisis. However, back when AT-1 bonds were originally introduced, there weren’t a lot of takers. Nobody was willing to lend money in return for one of these bonds. Which is when banks were forced to add a call option alongside these instruments. This option allowed the banks to prepay investors before maturity. The norm was set at 5 or 10 years. Meaning, lenders could now expect to see their money at some fixed date in the future. It didn’t feel like a perpetual waiting exercise.

However, once again there was no obligation for the bank to trigger the call option and return the money. It was still at the bank’s discretion. More importantly, they could even skip making the interest payment if they failed to turn a profit. So by all measures, these bonds were risky as hell.

And then things got worse. When Yes Bank was crumbling under pressure, the RBI intervened, assumed full control of the bank and brokered a bailout. Following which all Yes Bank AT-1 bonds were written off. This meant the bank no longer had an obligation to pay the interest or exercise the call option. For all practical purposes, the bonds were deemed “cancelled” and they were pronounced “worthless.”

It was a sad ending, but one that sent alarm bells ringing all across the board.

Several mutual fund houses held boatloads of these bonds and marketed their schemes as being “safe” and “secure”. To prove their point they’d also show you how most bonds in the scheme came with short maturity periods.

Think of it this way — “If bonds held by a mutual fund house were expected to mature in 3 months, that would give people a lot of confidence. After all the likelihood of things going south over such a small period is rather negligible. It’s safe to assume you’d receive your money in full.”

But what happens when you add AT-1 bonds to the mix?

Well, if you have a scheme with bonds that on average mature in 6 months, adding a single bond with a term lasting forever (infinite duration) would take the average to infinity and beyond. It would make the whole scheme a perpetual. But usually that's not how we do things. And with AT-1 bonds, fund houses kept using the call option as a get-out-of-jail card. They’d assume the bonds would mature in 5 or 10 years when the options were due. And to be fair to these people, it’s what the market assumes as well. Most banks do exercise the call option, because if they don’t, every investor out there will automatically assume the bank is in deep trouble.

"Why isn't the bank paying back?"

"Is the bank running out cash?"

"Will it fail?"

There will be speculation and it will destroy any institution. So it makes sense to assume these AT-1 bonds would mature with the exercising of the call option. However, accounting for it this way gives mutual fund investors a false sense of security. They don't know about perpetuals and the risk associated with them. So the regulator had to intervene and few days back, SEBI made some big changes.

For starters, fund houses that promise investors their scheme only hold bonds that mature in a certain fixed period, can no longer buy into these AT-1 bonds. Even others are expected to limit their exposure to 10%. Meaning, these bonds can’t make up more than 10% of their portfolio. These are by all accounts much-needed changes. But there was one other bit that ruffled a lot of feathers— “SEBI also mandated fund houses to value these perpetual bonds as if they’d mature in 100 years.”

And that changes a lot of things. Think about it — Until now, they would value these bonds as if they’d mature in 5 or 10 years. They believed they would receive their money in that time frame. But now if they’re told by SEBI to change that worldview, they would have to assume that they’d only receive their money 100 years later. Imagine waiting 100 years. That’s as good as never seeing your money. And if you were the mutual fund house, we ask you this —Would the bonds still be as valuable to you? No, they wouldn’t.

In fact, regulations would mandate you to reconsider your valuation.

So the value of these bonds and the value of their funds could possibly plummet overnight. This could trigger a panic wave with investors choosing to redeem their funds en masse. Which could then put the whole fund house at risk. So soon after SEBI released it’s circular, the Finance ministry intervened asking the regulator to reconsider this last point. Once again, bear in mind, fund houses are very happy to value these bonds based on their existing worldview. In fact, when these bonds exchange hands (which is rare), they are still valued as if they’d mature in 5 or 10 years alongside the call option. But SEBI wants everyone to look at it differently and it’s making a lot of people sweat. That’s it!!!

That’s the story. And while it is extremely complicated, we tried to simplify it as much as we could. We might also have toed the line and oversimplified a few things. So thank you for bearing with us. And if you found this account useful, don’t forget to share this article with your friends, family and colleagues (On WhatsApp, Twitter and LinkedIn)

Until then…