Perpetually yours !

The last few days have been quite a ride for long term debt and balanced mutual funds - the market regulator brought in a key change in the valuation methodology for perpetual bond, only to be stumped by an immediate directive by the Finance ministry to let things stay as they were. 

What is the issue here and why is it so interesting and important to track this soap-opera ?

What is a perpetual bond ?

–In the Indian context, these bonds are largely issued by PSB’s and govt owned institutions and the investors are mostly long term debt mutual funds.

Essentially this is a bond which keeps paying coupon rate to the investor till perpetuity, there is no stated maturity date (so no date for principal repayment) . However it usually also has an inbuilt call and/or put option embedded after say 5 years. So you can thus argue that this is like a 5 year bond for both issuer and investor and can be valued accordingly by both parties, called the Yield to call valuation model (YTC). 

Devil in the details

Could not be farther from the truth. These bonds have certain other unique features which are critical but ignored in the above pricing model

• Optionality for the investor is only ‘theoretical’ in nature – Remember Yes Bank AT1 Bonds issue. In cases of restructuring/insolvency, the optionality is revoked and investors cannot exit. Remember it is impossible to sell these bonds in secondary market in these circumstances. The YTC Model assumes you get your principal back during option expiry but you actually don’t
•  These bonds need to pay coupons only if the issuer is able to under certain conditions like profitability and availability of reserves. So not only are you stuck with dead investment, forget the coupon payment as well
•  The coupon payment is non-cumulative. So if you lose it for a year, you never recover that back.

So what happened now ?

None of these risks is priced in the YTC model, placing the MF Investors and industry at a great deal of unknown non-priced risk. Post the Yes Bank and LVB perpetual bond saga, SEBI has decided now to correct this and has suggested an alternative YTM model – essentially asking the MF Industry to value the bonds as if they will be paid interest for 100 years and principal after that. This will mean changes to a few critical risk factors

• a higher duration for the credit risk period (100 years against 5 years now) and
• a higher interest rate sensitivity built in (additive increase due to interest rate risk from year 6 to year 100, plus the risk of forecast over a longer period of time as India does really have a usable YC even for 10+ years). 

The impact of this higher risk recognition will be higher bond yield and lower bond prices. But seems the logical and right thing to do

Why did the government ask the decision to be reversed back ?

Just as the MF industry was getting their calculators switched on to compute the drop in NAV and their bond holding losses, the Finance ministry directed SEBI to hold back this change.

They had a very valid concern – the rule was to be implemented 2 weeks from hence. Any sudden drop in prices would have led to a ‘Run on the bank’ type of situation with large scale redemptions by MF Investors. We would have had a repeat of the Franklin Templeton type of scenario, not to forget the spillover it would cause to the equity market. Remember there is no liquid secondary market and MF would have had to redeem their equity holdings. The MF industry operates with low cash holdings and an impeccable track record of paying back monies. Any redemption issue would have been catastrophic, nothing less

Any other reasons why this is so important ?

Yes – the love for perpetual bonds. Post Covid, across the world there is a huge strain on public finance due to the need for higher fiscal measures and a tremendous risk of higher inflation. The sensitivity of public finance to interest rates is also possibly the highest.

In these circumstances, perpetual bonds would be the instrument of highest choice for governments to finance their expenditure as they need to pay only the coupon. The current low rates which can be locked by the government provides them a high leverage not seen before. So the government definitely does not want the market for these bonds to be dried up

What happens now ?

The immediate bloodbath may have been averted but given the way this has played out, the Mutual fund industry and investors will price the higher risk of these perpetual bonds in. SEBI will still try and have some other safeguard mechanisms built in. Long term, it will be difficult for PSB’s to be able to get investors for its perpetual bonds without the right pricing (remember RBI struggling to get any buyers for its bond auctions for the past 3 months and struggling to rein in the bond yields).

The government though may still have some gunpowder in its ammunition –

• Issuing tax free perpetual bonds (like the infra bonds). They will not mind losing a bit of tax revenue for a year to get the funds at cheaper issuer determined rates
• Issue sovereign bonds and nudge the PSB’s and LIC’s buy them, provide them the HTM status where they do not have to mark to market their losses when the interest rates eventually go up.

It is only going to get a lot more interesting :-)

Mutual funds sahi hain ? Will you invest ?