Perpetual bonds of banks often yield a higher rate than the interest on fixed deposits. They are marketed to retail investors, especially retirees looking for a regular income. For instance the yield on SBI perpetual bond (as of 15 May) on BSE was 8.58%. This is considerably higher than the 5-7% offered on SBI FDs. For Syndicate Bank, the yield was as high as 10.75%. 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 pre-defined thresholds. Here are the risks of investing in this investment product:
Default Risk
Unlike fixed deposits (which have a guarantee up to ₹5 lakh), 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 to equity than debt. Investors should not become complacent simply because the issuer is a public sector bank. Since perpetual bonds are seen as a risk absorbing instrument, PSU bank may write them down without necessarily causing a crisis of confidence in the market. Bond investors are not treated with the same care as fixed deposit investors, as the example of Yes Bank shows.
In March 2020 when Yes Bank faced a crisis, the bank chose to write down the entire value of some of its perpetual bond (called AT1s), 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. Many of these perpetual bonds had been sold to retail investors by the bank’s relationship managers.
Nishith Baldevdas, a Chennai-based Sebi registered investment advisor also pointed out that these bonds have concentration risk due to their large ticket size (minimum ₹10 lakh). Investing in a debt mutual fund with the same amount of money can get you access to a portfolio of 20-50 different kinds of debt paper and 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 practical terms, 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.
Banks Under Stress Due To Covid-19
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 in which a borrower can temporarily halt repayments on loans until the lockdown period ends. However there is no guarantee that the economy will revive immediately and fully after the lockdown. 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 NPAs and wipe out perpetual bonds. Remember, loss absorption is the very purpose of these bonds.
Liquidity Can Dry Up
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 forcing Franklin Templeton Mutual Fund to wind up six of its debt funds on 23 April. Hence investors should not look upon these bonds as an emergency fund. Most bank fixed deposits by comparison 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).
Inflation Risk
Inflation risk applies to all bonds. 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). Why? 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 shoots 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 and hence also for perpetual bonds. A drop in the bond’s price does not hurt if you if you intend it hold it to maturity. However, if you want to sell it before maturity, you will get a lower price for your bond in the market. This is due to the effect on bond prices of an interest rate hike.
As RBI cuts 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 risks mentioned above before putting your hard earned money in them. “In debt, you should prioritise 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.