Why is Market worried SEBI’s New Norms on Perpetual

Bonds?
The people in the market are in fix about SEBI’s new perpetual bonds. So
before we proceed lets try to understand the word perpetual bonds, is
a bond with no maturity date. Therefore, it may be treated as equity, not as
debt. Issuers pay coupons on perpetual bonds forever, and they do not have
to redeem the principal.

Now talking about ,The Mutual Fund industry operates on a simple premise. In
simple words we can say that  regular investors have little know-how about the
complexities inherent in the stock market. Therefore a better approach is to let
experienced fund managers take care of business for an individual.
And while there are many ways professionals can choose to manage your
money, the most popular avenue is to create a mutual fund. This way
companies can take investors money, divert it to a common pool of funds — 
mobilized from other people and invest this massive corpus in handpicked
stocks to offer investors good returns. All this for a small fee.

It seems like a win-win for everyone involved. But not everybody wants a piece
of the Indian stock market and not everybody wants to experience this wild
crazy trip. The ups and downs can be too much. It’s never a good feeling to
hear that your fund is down 10% because the stock markets continue to
tumble. So for the faint-hearted, they offer another alternative — a debt
mutual fund.

Now they will use investors money to lend to corporates and governments,
instead of buying stocks from select companies. In return, the corporate will
promise to pay the fund house the entire principal and a fixed sum on top. The
contract agreement is called a bond. The time frame — Maturity Period. And
the fixed return on top is called the yield.

Unlike equity mutual funds, where the fund house is exposed to the swings of
the market, debt mutual funds offer more consistent returns. Once a fund
house invests in a bond, the corporate is liable to pay back the principal and
the yield, in full, failing which the fund house can drag the corporate to
bankruptcy court.
Now lets look at  Perpetuals and AT-1 Bonds. Perpetual bonds don’t have a
fixed maturity. So there’s no obligation for the borrower to pay back the
principal and that extra yield on top, ever. Perpetuals might not offer you the
principal, but they do offer periodic interest. This is what gives them value.And
the AT-1 bond (central to this story) is a perpetual.

Banks issue these bonds in a bid to raise money and cushion their coffers. It’s
to make sure these institutions have enough cash to stave off a crisis.
However, back when AT-1 bonds were originally introduced, there weren’t a
lot of takers. Nobody was willing to lend money in return for one of these
bonds. Which is when banks were forced to add a call option alongside these
instruments. This option allowed the banks to prepay investors before
maturity. The norm was set at 5 or 10 years. Meaning, lenders could now
expect to see their money at some fixed date in the future.

However, once again there was no obligation for the bank to trigger the call
option and return the money. It was still at the bank’s discretion. More
importantly, they could even skip making the interest payment if they failed to
turn a profit. So by all measures, these bonds were risky as hell.

When Yes Bank was crumbling under pressure, the RBI intervened, assumed
full control of the bank and brokered a bailout. Following which all Yes Bank
AT-1 bonds were written off. This meant the bank no longer had an obligation
to pay the interest or exercise the call option. For all practical purposes, the
bonds were deemed “cancelled” and they were pronounced “worthless.”

Several mutual fund houses held boatloads of these bonds and marketed their
schemes as being “safe” and “secure”. To prove their point they’d also show
you how most bonds in the scheme came with short maturity periods.

If bonds held by a mutual fund house were expected to mature in 3 months,

that would give people a lot of confidence. After all the likelihood of things
going south over such a small period is rather negligible. It’s safe to assume
you’d receive your money in full. But what happens when you add AT-1 bonds
to the mix?

Well, if we have a scheme with bonds that on average mature in 6 months,

adding a single bond with a term lasting forever (infinite duration) would take
the average to infinity and beyond. It would make the whole scheme a
perpetual. But usually that's not how we do things. And with AT-1 bonds, fund
houses kept using the call option as a get-out-of-jail card. They’d assume the
bonds would mature in 5 or 10 years when the options were due. And to be
fair to these people, it’s what the market assumes as well. Most banks do
exercise the call option, because if they don’t, every investor out there will
automatically assume the bank is in deep trouble.

There will be speculation and it will destroy any institution. So it makes sense
to assume these AT-1 bonds would mature with the exercising of the call
option. However, accounting for it this way gives mutual fund investors a false
sense of security. They don't know about perpetuals and the risk associated
with them. So the regulator had to intervene and few days back, SEBI made
some big changes.

Fund houses that promise investors their scheme only hold bonds that mature
in a certain fixed period, can no longer buy into these AT-1 bonds. Even others
are expected to limit their exposure to 10%. Meaning, these bonds can’t make
up more than 10% of their portfolio. These are by all accounts much-needed
changes. But there was one other bit that ruffled a lot of feathers—  “SEBI also
mandated fund houses to value these perpetual bonds as if they’d mature in
100 years.”
And that changes a lot of things. They believed they would receive their money
in that time frame. But now if they’re told by SEBI to change that worldview,
they would have to assume that they’d only receive their money 100 years
later. That’s as good as never seeing your money. In fact, regulations would
mandate you to reconsider your valuation.

So the value of these bonds and the value of their funds could possibly
plummet overnight. This could trigger a panic wave with investors choosing to
redeem their funds en masse. Which could then put the whole fund house at
risk. So soon after SEBI released it’s circular, the Finance ministry intervened
asking the regulator to reconsider this last point. Once again, bear in mind,
fund houses are very happy to value these bonds based on their existing
worldview. In fact, when these bonds exchange hands (which is rare), they are
still valued as if they’d mature in 5 or 10 years alongside the call option. But
SEBI wants everyone to look at it differently and it’s making a lot of people
sweat.