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A Problem of Valuing the Perpetuity

In this week's FinMail, we are going to discuss SEBIs new circular to all the Mutual Fund Houses regarding Perpetual Bonds and how it created fear amongst everyone that even Finance Ministry had to step in and ask SEBI to withdraw it.

The Story:-

SEBI in its circular on Wednesday ordered Mutual Funds to cap their Investments in Bonds with special features known as Additional Tier bonds or Perpetual Bondsup to a limit of 10% of the scheme's total Investment and also value them as 100-year securities. This move has sparked some serious fear in the minds of Industry Participants as well as the Fund Management Houses as this can potentially trigger panic selling from Investors and Mutual Funds to a large extent. The fear has been so deep that the Finance Ministry had to step in on Friday to ask SEBI to withdraw its circular. What does it mean for an investor holding these mutual funds and what exactly the new circular states, we will look into everything today. So let's start straight away.

What are Perpetual Bonds?

As we know, bonds are a form of a certificate or a contract that certifies that a borrower (a company or a government) has borrowed money from an investor (individual, company, or government) and is liable to pay interest periodically and principal at the end of the period. Perpetual Bonds, as the name says are Perpetual (Infinite) in nature. They don't have a maturity date and could pay coupons for an infinite period. The subscriber of Perpetual Bonds will not receive his principal back but would receive a coupon as a form of interest periodically for an infinite period. As they don't have a maturity date plus also pay a regular amount of interest as fixed income, they are also compared with Equity Shares. They are considered riskier bonds, and thus only some companies issue these types of bonds because investors don't trust everyone with their money which is to be kept forever.

However, perpetual bonds do have a 'call option' which means that the issuer can redeem the bonds by paying back the principal amount to its subscribers. Such an option lies only with the issuer and not with the investor. The call date is pre-determined at the time of the issue only.

So for example, if ABC Ltd. has issued perpetual bonds with an 8% coupon on face value ₹100, it means that ABC Ltd. has promised to pay ₹8 every year (infinitely) to the purchaser of the bond. The bond states that ABC Ltd. has the right to call back those securities 5 years from the date of issue upon which the principal will be paid back and the coupon will not be payable further on.

It is a normal practice in India and throughout the world that the issuer will call back these bonds on the date of the call option and thus they are not actually perpetual but fixed period security (in practice). However, as this option is with the issuer only, it is also possible that the issuer will not call back the bonds. The decision to redeem or not to redeem lies totally with the issuer. This is the major risk factor in perpetual bonds.

SEBI's New Guideline and its Impact.

Simply Put, SEBI's new circular orders Mutual Funds the following things:

  • Fund Houses should not invest more than 10% of the total scheme's funds in Perpetual Bonds.

  • Not more than 5% of a scheme's funds should be invested in a perpetual bond of a single issuer.

  • Not more than 10% of the fund house's corpus (all schemes' total fund value) should be invested in a perpetual bond of a single issuer.

  • For the purpose of valuation of these bonds, their maturity should be taken as 100 Years.

The impact of this circular was such that even the Finance Ministry had to step in and ask SEBI to withdraw part of the circular that asked Mutual Fund houses to value Perpetual Bonds as bonds with a maturity of 100 years.

What is the impact?

As of this month, the total issued Perpetual Bonds stands at ₹90,000 crores of which ₹35,000 crores is held by Mutal Funds only. [via Bloomberg] In India, most of the Perpetual Bond Issuers are banks that borrow money to fund their long-term capital or the core capital needs. With SEBI placing the cap on the mutual funds to limit their exposure in Perpetual Bonds, those funds that hold more than 10% of the scheme funds will not have any impact but will be unable to invest more. However, this is not the reason why the FinMin had to step in. The reason is changes in the Valuation method. SEBI has asked to value these bonds as bonds that mature in 100 years. This is the major problem that is feared.

The Current Valuation Method

As we discussed earlier, though the bonds are issued as perpetual bonds, the normal practice in India and all over the world is that the issuer redeems the bond at the call date and doesn't usually keep them perpetually. So the market values these bonds as the bonds that are going to mature after 5-10 years (usually the call dates are between 5-10 years) and fund houses also follow the same market price to value such securities in their portfolios. Now that SEBI has asked the fund houses to value the bonds based on 100-year maturities, the book values of these bonds are bound to go down. Why so?

Not jumping into details of how valuations work in this week's issue, assume that you are willing to lend some money to your friend. If your friend says that he will pay you back in 10 years, you agreed to lend him the money at 10%. Now, what if he says that he will pay you back after 40 years. You'll definitely ask for more interest from him or even deny lending the money. Now that your interest to lend someone for a longer period is decreased, the value of that loan certificate or bond will decrease because you are not interested.

So of course for the same reason, the book value of these bonds will decrease when valued through the new method. An important thing to note here is that there is no change in the call date or the redemption value. The bond will get redeemed after 5-10 years only depending on the exercise by the issuer. Only the valuation method has changed. This means that there will be a sudden drop in the values of these bonds in the fund's portfolio which will also impact the respective NAVs of the schemes. Fund Managers expect a 4%-8% drop in NAVs of the schemes depending on their holdings. Due to the drop in NAVs investors in these schemes might start panic selling which might put stress on the liquidity of these schemes similar to what happened with Franklin Templeton back in April. Alternatively, to prevent the drop in the NAV, fund managers might also try to exit these bonds which will trigger a selling spree in the Bond Market. This will push up the overall yields of other Debt Securities as well. This will mean that it will be more costly for the banks and other companies to borrow from the market as they will have to pay more to borrow.

Why the FinMin had to step in?

Due to the fear of triggering a selling pressure in these bonds, the FinMin fears that it will make borrowings for banks more costly and hence the banks will have to depend more on the government for capital borrowings. Banks favor perpetual bonds for borrowing for their core capital use and when the largest buyer of such bonds will be limited by SEBI, banks will have to go to someone else to raise funds and to whom do the banks go crying to when nothing works? The Government, of course.

Why SEBI had to take such a step?

Perpetual bonds are risky, period. After the Franklin Templeton episode, SEBI had to do something to prevent such events in the future. SEBI has probably made this decision after the Reserve Bank of India (RBI) allowed a write-off of Rs ₹8,400 crore on AT1 bonds issued by Yes Bank Ltd after it was rescued by the State Bank of India. (SBI) [via Indian Express]

SEBI has to take some measures to cut down the exposure of common investors who invests in these bonds through Mutual Funds from losing their hard-earned money to the failure of some bank. But this measure could turn out to be troublesome for the government, as the threat lies that the debt market will observe pressure due to this movement and banks would soon start knocking on the doors of the government for money.

What does AMFI have to say on this move?

AMFI has welcomed the move of SEBI for the cap as well as the valuation guideline. AMFI feels that the issue is actually narrow or small than how big it is being made. As per AMFI, the valuation of such bonds is based on the market value of the bonds and as the remaining market will continue to value these bonds according to the call dates, it is not of concern. Only in the case when there are no securities traded in the market, the question of this valuation method arises. However, on the cut down of NAVs, AMFI is in talks with SEBI on what is to be done to minimise the loss to the investors.

What about the Investors in the Mutual Funds?

Our POV:-

Anything that happens, guns are always pulled on the Retail Investors. And yet again Investors are the shoulders on which the gun would be fired. The NAV is certainly expected to decrease by 4%-8% from 1, April 2021. However, you should note that this is not your actual loss. This is just a valuation write-off. Neither the interest receivable is going to change nor the principal. But the change of NAV (positive) will only take effect after the bonds are redeemed and not anytime further. Hence the investors who were going to hold anyway till the next 5-10 years (or less if most of the bond's call dates are approaching soon) will not be affected. It is the short-term investor who had parked his money for a short term that will be affected. We suggest you not to panic sell any of the funds that you hold and wait till there are any updates. There is time till the effect takes place. We will keep you updated about the same on our Instagram Account as well. We also intend to continue this topic in the next week's FinMail as well unless there are any major updates.

Join us live today on our Instagram account where we discuss these and answer your queries if any.

That is it for this week's FinMail, till then keep learning, don't panic sell and we will see you in the next week.

Tweet your questions and review on @YourFinMan.


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