How perpetual bond can turn into a trap for investors 

TBS Illustration

Although perpetual bonds have opened up a new avenue for investment, it risks turning into a trap for investors as the investment tool does not guarantee the payment that issuers promise to continue forever. The Bangladesh Bank can stop the servicing of interest, and even the payback of the principal amount, if it sees erosion of the financial health of the issuer banks. 

In other words, the perpetual bond comes with a condition that Bangladesh Bank can at any time stop interest payment and principal for the issuer banks and if any other contradictory condition is applied by any other authority, the central bank will not allow banks to show the bond as a capital instrument. 

Bangladesh Bank imposed such conditions in accordance with the Basel III standard when giving no objection to the issuers for showing the perpetual bond as its Additional Tier 1 (AT1) capital. 

This rule is applicable only for perpetual bonds which are unsecured and without maturity, not for other asset-backed secured bonds.

Perpetual bonds were issued to raise AT1 capital while the Bangladesh Securities and Exchange Commission (BSEC) is the authority to give its approval. 

The conditions that the Bangladesh Bank has imposed should be a cause of concern for investors keeping India's Yes Bank crisis in mind which acts as a stark reminder of the pitfalls of perpetual bonds.

The Reserve Bank of India (RBI) had to write off Yes Bank's AT1 bonds worth Tk9,677 crore last year after taking over the bank to avoid its total collapse, which would have left the retail investors, who had invested in the perpetual bond, facing all-out losses. 

The conditions that the Bangladesh Bank has imposed should be a cause of concern for investors keeping India's Yes Bank crisis in mind which acts as a stark reminder of the pitfalls of perpetual bonds.

When the AT1 bonds were written off, the bank no longer had an obligation to pay the interest or exercise the call option. For all practical purposes, the bonds were deemed worthless.

Though perpetual bonds are a relatively new investment concept in Bangladesh, the same risks could await future investors as the regulations seem to be heading in the same direction. 

By including various conditions, Bangladesh Bank essentially reduces the obligation of issuer banks in paying investors back their money. Simultaneously, the BSEC is heading in the opposite direction by opening up the option for the involvement of retail investors, by making the aforementioned bonds tradable in the stock market. 

For instance, Bangladesh Bank put in a convertibility clause for the perpetual bond issuer in the case of common equity Tier-1 capital shortfall for three consecutive quarters.

According to the central bank's requirement, if the common equity Tier-1 capital remains less than the regulatory threshold of 4.5 percent of total risk-weighted assets of the bank for three quarters in a row, the bank will have to convert a portion of the debt into common equity.

The central bank put the convertibility clause following the guideline on risk-based capital adequacy, which gives banks full authority to cancel the payment of such  (perpetual) bonds while ensuring that the issuer will not be labelled as a defaulter for cancellation.

The convertibility clause will protect the issuer bank when it is in financial danger but leave the investors holding the bag. 

This is because if the bank experiences capital erosion, the bond can easily be converted into equity and relieve the bank of the obligation to pay interest and the principal amount to the investors.

When the bondholders will turn into equity holders, they will get dividends as general shareholders. However, the bank only has to declare dividends when it reports earning a profit. In other words, this is how perpetual bonds cannot guarantee the payment of investors. 

With retail investors yet to be familiarised with complex investment instruments like perpetual bonds, the BSEC is continuing to make the bonds tradable to give an exit option for investors. It also wants perpetual bonds to be excluded from being included in capital market exposure reports. 

The exclusion of perpetual bonds to capital market exposure is detrimental for the financial market as trading in the stock market could have helped spread the risk to retail investors as they often have trouble critically analysing the risk and rewards of investing in such volatile bonds. 

In Europe, there are restrictions on selling such bonds to retail investors. 

Earlier, in July last year, the BSEC decided that all the perpetual bonds issued by banks must be tradable on the main board of the local bourses. However, no perpetual bonds have been listed yet.

Though listing is not mandatory in the guidelines regarding risk-based capital adequacy for AT1 bonds, the BSEC has made it mandatory for issuers to involve retail investors. 

From mid-2020 to now, the commercial banks have begun to get regulatory approval for perpetual bonds and 15 banks are collecting Tk6,000 crore in total through the newly popularised instrument.

Four banks have so far successfully completed subscription and are in the process of listing.

The exclusion of bonds from capital market exposure calculations is likely to put banks at risk as the Bangladeshi market already suffers from a lack of transparency, industry insiders said.

This is because banks will be forced to invest in such bonds instead of focusing on company-specific risks. 

Since banks are the biggest investors of such perpetual bonds, one bank will often invest in another bank's bonds. As a result, if one bank experiences a crisis, other banks with vested interests will be at risk. 

Globally, high net worth individuals, hedge funds, corporations, alternative investment funds and pension funds are allowed to invest in such perpetual bonds. But, in Bangladesh, high-risk perpetual bonds are being allowed to float before creating a large investor base.

The BSEC has been lobbying the Bangladesh Bank to allow banks to report capital market exposure excluding bond investments.

"The capital raised through perpetual bonds will not be included as capital market exposure for banks, even after such an instrument gets listed on the stock market", said Shibli Rubayat Ul Islam, the Chairman of the BSEC while addressing the subscription closing ceremony of perpetual bonds, organised by the City Bank recently.

However, the Bangladesh Bank did not address the issue yet despite having the authority to relax the rule.  

The bond investment of banks already raised concerns for Bangladesh Bank as the current development of the bond market only rides on banks, which adds to the risk associated with the banking sector. 

The bond market is supposed to develop as an alternate source of money for corporations, said a senior banker anonymously.

But recent bond development trends show that the corporations are forcing banks to buy their bonds, s/he said. 

As a result, banks chose bond investment instead of lending. However, lending is safer than bond investment for banks as borrowers have an obligation to pay back the money. 

Moreover, lending is secured by collateral. But in the case of bonds, issuers have less obligation to pay back the money as there is no collateral, which puts the banks' investments at risk, s/he explained. 

Pricing of perpetual bonds is another risk for investors 

Regarding the pricing of perpetual bonds, the company-specific risk was not taken into consideration. 

The interest rate is fixed at the 20-year Treasury-Bond rate plus 2 percent for conventional bonds while for Islamic banks that rate is equal to the one-year deposit rate plus 2 percent.

However, issuer banks were not categorised according to their quality of assets in the case of fixing interest rates. The identical pricing of perpetual bonds will broaden the risk for retail investors after listing, explained an issue manager seeking anonymity. 

"Bond pricing should be market-based. But in Bangladesh, the pricing is controlled by the central bank, which does not reflect proper risk premia," s/he said.

"Such highly complex bonds are not suitable for retail investors", s/he added. 

Moreover, the manager explained that the same pricing causes some issuers to face problems raising funds in private placement. 

Before buying bonds, investors should do a detailed cash flow analysis and make sure they are investing in financially secure and well-reputed institutions. However, the yield available from high-quality corporations is normally much lower compared to riskier ones worldwide.

For example, in 2019, the yield to call of HDFC Bank perpetual bonds was only 8.27 percent compared to the yield to call of 18 percent from Yes Bank in India, according to media reports.

Furthermore, perpetual bonds normally come with a call option—the issuers 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 the investor and not for the issuer.