SEBI on Perpetual Bonds: What it is and How does it impact us?

For our first post, we wanted to simplify not only something that was complex, but also current, to help us live up to what we want the blog to do — simplify complex financial topics and keep you updated on the financial world. And while we were confused between rising bond yields and outflows from the equity Mutual Funds (MFs), the Securities and Exchange Board of India (SEBI), the entity that regulates the Indian securities markets, came out with a regulation capping the amount of money that MFs can invest in perpetual bonds and also changing the valuation method that MFs followed for these bonds, and we knew we had to cover this first.

In this blog post, we will try to simplify the concept of perpetual bonds, while also trying to understand why SEBI decided to enable these changes, and how it affects the financial markets in addition to the existing and prospective investors in the debt instruments of these MFs.

The outstanding corporate bond issuances, as per the latest CRISIL Yearbook on the Indian Debt Market, stood at INR 33 lakh crores, or ~16% of the GDP (End of Fiscal 2020), which is further expected to double to INR 65 to 70 lakh crores by the year 2025. Perpetual bonds form an important part of this number, with institutions like SBI, Bank of Baroda and Rural Electrification Corporation using this route in the last one year to raise debt capital.

The new guidelines on perpetual bonds, however, cap the amount of money a fund manager can invest in the bonds to 10% of the total money being managed by them, in addition to the cap on a single borrower being 5%. Secondly, on the valuation front, SEBI has advised the fund managers to take the life of the perpetual bonds they have invested in as 100 years, instead of the window of 2 to 10 years they have been taking till date.

As the implication of these guidelines are complicated, it may be important to start by understanding what perpetual bonds are in the first place, and also how they function:

Perpetual Bonds, in simple terms, are debt instruments that don’t have any repayment of principal. Instead coupon payments, or interests, are expected to be made till perpetuity. These perpetual bonds carry a higher interest rate due to their risky nature. This mechanism allows entities like Banks and Non-Banking Finance Companies — which borrow money to further lend to other entities — manage their cash flows, as their obligations towards their lenders are spread out.

These bonds, however, are not very popular due to their complicated nature, and hence see participation primarily from institutional players like MFs, Insurance Companies and Pension Funds, alongside HNIs. Hence, capping the amount of money that MFs can invest in the segment significantly brings down the amount that can be raised by the institutions through this route, which impacts the overall market — negatively.

SEBI, in their understanding behind this new regulation, has tried to protect the interest of the existing investors in debt mutual funds. On two occasions in the past one year, as some may be aware, private sector banks decided to completely write off the perpetual bonds they had raised from the markets due to financial stress they were facing. Investors in Mutual Funds, which had high exposure to these bonds saw their invested money get impacted negatively, even though the debt funds are expected to be safer and less volatile than equity funds. It is widely understood in the market that SEBI has decided to put a cap because of these instances.

Coming to the guidelines on valuations, taking the maturity of the perpetual bonds as 100 years is a departure from the valuation method that fund managers have been following till date. These bonds, to understand the mechanism earlier followed by Mutual Funds, come with a ‘Call’ option, which provides the issuer with an option to purchase these bonds back from the holder on a given date, if they have the cash available to do so. This, hence, makes the perpetuity of these bonds more of a choice for the issuer than a mandate.

Mutual Funds used to earlier take the call date as the date of the maturity of these bonds. The shorter life of the bond has allowed for a higher valuation of these bonds and changing the maturity life to 100 years will negatively impact the current valuation of these bonds. A drop in valuation of these perpetual bonds will hence have a significant impact on the capital of the investors in the MFs with exposure to these bonds, leading to negative returns in the shorter run.

Due to these reasons, the regulations have led to some disturbance in the financial markets, with even the Department of Financial Services of the Ministry of Finance coming out with a request to SEBI to withdraw these new guidelines. The Association of Mutual Funds in India, on the other hand, has come out in support of these guidelines. Hence, it will be interesting to see the way SEBI turns on these guidelines.

Disclaimer: The views expressed in this article are personal, and are not to be associated with the organisations we are a part of.