Yes Bank crisis to hit LIC customers

Additional Tier 1 (AT1) bonds are issued to raise Additional Tier 1 capital, as per the Basel III norms, they ensure that a financial insitution's capital requirements are met. Perpetual bonds are seen as riskier quasi-debt instruments which do not have fixed maturity. Issuers pay coupons on these forever. The price of a such a bond is the coupon amount divided by a constant discount rate. Since they have no maturity date, investors can get their investment back only by selling them in the secondary debt market unless the issuer calls the bonds back, i.e. redeems them. When the issuer sinks, like Yes Bank did, it is unlikely to redeem the bonds on its own and for investors, finding buyers becomes near impossible.

Last year, there was a huge inflow of perpetual bonds into the market by banks, NBFCs. With liquidity being an issue and the NBFC crisis spooking investors, entities were forced to announce higher coupon rates. Consequently, the yield being offered was much higher than fixed deposit rates which lured some retail investors who were unaware of the risks. To make sure you don't fall prey to such an occurrence in the future, know about these risks associated with perpetual bonds.

Though the bonds are issued by large corporates, investors should understand the implications of the company going into liquidation, in which event, perpetual bonds are subordinate to senior bonds, say financial experts and to claim final receipt, their status is just above that of preference shares. This means that perpetual bond investors will be paid after all other claimants like depositors, other bond holders, etc are paid. Preference and equity shareholders will be the ones to be paid after that.

Perpetual bonds are unlike regular bonds where interest has to be paid regardless of whether the issuer is running a profit or loss. If there are no free reserves to dip into, no interest payment will be made in case of loss in a year by the issuer, according to experts. Free reserves are created out of profits from previous years.

Another restrictive feature is tier 1 perpetual bonds are non cumulative. What this means is that interest that does not get paid in a year due to the company incurring loss, does not build up. Therefore, bond holders are not eligible to get the same in later years even if the company makes a profit.

Further, perpetual bonds normally come with a call option— the issuers have the right to call (redeem) these bonds early. This means these institutions will call (redeem) them back if interest rates fall from current levels but will not if interest rates rise. In other words, these bonds are perpetual only for the investor and not for the issuer. Yield calculation is also different. Experts say that due to the call option, investors should calculate yield to call (YTC) instead of yield to maturity (YTM).

Unlike for other bonds that have a maturity date when the issuer returns the principal, for perpetual bonds, liquidity is critical because selling in the secondary market is the only option available. However, liquidity is low and the bid-ask spread is high.

In addition to the above-mentioned broader risks, investors should note that there are company-specific risks too. They should first look at their own risk appetite, then consider only perpetual bonds issued by financially very sound and healthy institutions, after evaluating the risks associated with these bonds. Doing a detailed cash flow analysis is recommended. Also note that the yield available from high quality corporates is normally much lower compared to that from risky ones. For example, in October last year, the YTC of HDFC Bank perpetual bonds was only 8.27% whereas the YTC from Yes Bank was 18%.