Perpetual bonds are offering higher interest rates than fixed deposits: Should you invest?
The yield being offered by these bonds are significantly higher than fixed deposit rates and therefore, it is natural for investors to be interested. So should you buy these bonds? Here is a closer look at the risks involved with perpetual bonds.
So should you buy these bonds? The yield being offered by these bonds are significantly higher than fixed deposit rates (see chart) and therefore, it is natural for investors to be interested.
Investors should go by the yield to call, not yield to maturity
Issuers have the right to recall these bonds if the interest rates go down from current levels.
Source: NSCCL Platform; Data as on Oct 23; Table sorted on the basis of yield to call (ytc)
However, experts say investors should also understand the reasons behind the higher returns and get in only if they are comfortable with the associated high risks. “Investing in long duration bonds is a critical aspect of retirement planning. There is no problem in investing in perpetual bonds, but you should understand the risks involved,” says Ankur Kapur, Managing Partner, Plutus Capital. Deepak Jasani, Head of Retail Research, HDFC Sec concurs with this view. “While perpetual bonds from companies belonging to credible groups are worth a look, especially given the high taxable yields available, one will have to keep in mind the commensurate risks,” he says. Let us take a closer look at the risks involved with these bonds:
Though the bonds are issued by large corporates, investors should understand the implications of the company going into liquidation. “Perpetual bonds are subordinate to senior bonds in the event of liquidation,” says Jasani. “For claiming final receipt, the status of perpetual bonds is just above that of preference shares,” says Raghvendra Nath, MD, Ladderup Wealth Management. This means 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.
No profit, no interest
Unlike normal bonds, where interest has to be paid irrespective of whether the issuer is making profits or loss, the rules are different for perpetual bonds. “If there are no free reserves to dip into, there won’t be interest payment in case of loss in a year by the issuer,” says Jasani. Free reserves are created out of profits from previous years.
Another restrictive feature is tier 1 perpetual bonds are non cumulative. “Since the interest that did not paid in a year due to loss won’t get cumulated, bond holders won’t be eligible to get the same in later years even if the company makes a profit,” says Nath.
More importantly, perpetual bonds come with a call option—the entities have the right to call these bonds early. This means these institutions will call them back if the interest rates go down from current levels, but will keep them alive if the interest rates go up. In other words, these bonds are perpetual only for you and not for the issuer. Yield calculation is also different. “Due to the call option, investors should calculate yield to call (YTC) instead of yield to maturity (YTM) for these bonds,” says Nath.
Unlike other bonds that have a maturity date—when the issuer returns the principal, liquidity is critical for perpetual bonds 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 broader risks, investors should note that there will also be company-specific risks. Thus, invest only in healthy institutions. Before buying bonds, investors should do a detailed cash flow analysis and make sure they are getting only into strong institutions. However, the yield available from high quality corporates will be much lower compared to risky ones. For example, the YTC of HDFC Bank is only 8.27% compared to the YTC of 18% from Yes Bank.
Since doing a detailed analysis can be difficult for retail investors, they should stick to large PSU banks. “As there is tacit support from the government in the form of capitalisation, it is reasonably safe to buy perpetual bonds of PSU banks,” says Nath. Even among PSU banks, experts advise going with large and fundamentally strong banks. In the event the bank fails, the government may merge it with some other bank to save depositors, but perpetual bond holders may be ignored.
Investors also need to be aware that with so much of privatisation happening, a PSU bank can become a private bank later. Understanding the structure—whether an entity is a PSU or not—is also critical.
“Till it failed, several investors thought IL&FS was a government-backed entity. The whole purpose of investing in bonds is safety. If you don’t have the skill to understand company-specific risks, it is better to keep away,” says Ankur Kapur, Managing Partner, Plutus Capital.