As interest rates fall, bank fixed deposits are no longer attractive. Corporate deposits are also not popular with investors, except those issued by big companies, because of rising default in repayment of both interest and principal amount. So, is there a way to optimise returns and look at other long-term fixed income products? Perpetual bonds are one such instrument in the fixed income space. These bonds are just like any other fixed income instruments with no maturity.
How do they work
Typically, at the time of issuance, the issuer would set up terms for repayment, through a call option, say after five years or 10 years to give the investors an option to exit. At times, the issuer of the perpetual bond incorporates the ‘step up option’, which means that if the bond is not called/redeemed within a certain time horizon, the issuer will pay a higher rate of interest on bonds. These bonds are listed in the stock exchange and can be bought from the secondary market. It is not as easy to trade/buy as compared to shares, but then, there are bond dealers who facilitate the transaction.
Both private and public sector banks issue these perpetual bonds. As prescribed by the Basel III norms, public sector banks use them to augment the Tier I capital. Typically, these bonds are issued at a face value of R10 lakh per bond. A demat account is mandatory, if one needs to buy/sell these bonds.
Features of the bonds
Typically, these bonds have a higher coupon rate or interest rate as compared to the benchmark 10-year government securities. A steady predictable income over prolonged period of time is a major attraction to own them. In a falling interest rate regime, as witnessed over the past few months, the yield from the perpetual bonds has gone up.
Though predictable and higher interest rates are attractive, one also needs to consider the credit risk and default risk of the issuer. This makes investors prefer perpetual bonds issued by public sector banks. If the bonds are part of subordinated debt, it would not be backed by any assets, which in turn would lead to a lower credit rating.
Another point to remember is the liquidity risk, as the investor may not be able to sell the bonds, if the trading is low and the appetite for the bonds cease. Also, in a falling interest rate regime, the issuer may ‘call’ the bonds, so that a fresh issue can happen at a lower interest rate. It is important in this sense to note the ‘call’ period, before investing.
Again the reinvestment risk and interest rate risk, which is prevalent in all debt instruments, is also applicable here, but then depending on the call option period, the timing may differ.
The writer is managing partner, BellWether Advisors LLP