PERPETUAL BONDS and THEIR FEATURES - VRK100 - 31Aug2006

Perpetual Bonds and Their Features

Perpetual Bonds - Basics

What is a perpetual bond?

A perpetual bond is a bond with no maturity date. Perpetual bonds are not redeemable but pay a steady stream of interest forever. Their cash flows are therefore that of a perpetuity.  Perpetual bonds are those in which the investor does not have an option to ask for the money back. (But in some cases, the issuer has the right to pay back investors and redeem the bonds after a period of time). A perpetual bond is colloquially known as a Perpetual or just a Perp.

The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today. 

 

Some ultra long-term bonds (sometimes a bond can last centuries: Weat Shore Railroad issued a bond which matures in 2361 AD, i.e., 24th century) are sometimes viewed as perpetuities from a financial point of view, with the current value of principal near zero.

 What are its salient features?

Perpetual bond issues are quasi-equity, which qualify as Tier-I capital in India. They are having the qualities of both bonds and equities. Like bonds, they pay periodical interest to investors. 

 

And like equity shares, they do not have any maturity. That is why they are alternatively called as hybrid instruments. Such instruments are fit to qualify as Tier I capital in view of the fact that they had no maturity date.

 How are perpetual bonds priced?

Since perpetual bond payments are similar to stock dividend payments - as they both offer some sort of return for an indefinite period of time - it is logical that they would be priced the same way. 

 

The price of a perpetual bond is therefore the fixed interest payment, or coupon amount, divided by some constant discount rate, which represents the speed at which money loses value over time (partly because of inflation). 

 

The discount rate denominator reduces the real value of the nominally fixed coupon amounts over time, eventually making this value equal to zero. As such, perpetual bonds, even though they pay interest forever, can be assigned a finite value, which in turn represents their price.

Why the sudden interest in them?

Indian banks (including private sector banks) are raising funds to meet a surge in credit demand; expand domestically and overseas; and comply with new capital standards (Basel II norms) that take effect from March 2007. 

 

Indian banks’ lending increased by more than 35 percent in each of the past two years (2004-05 and 2005-06) as the economy grew 8 percent annually.

Public Sector Banks would require alternatives to raise Tier I capital since Government holdings in some of the banks have already reached 51 per cent. These banks are, therefore, not in a position to raise their equity capital, since it would entail dilution of government holding below the threshold. 

 

The government does not look too keen in pumping in fresh capital right now and as the economy is expanding banks will need more capital.  Accordingly, alternative forms of capital raising would be required in the form of hybrid capital. 

 

Perpetual bonds were used during the 1980s for recapitalisation of public sector banks and were discontinued since 1994. Some of the banks that returned capital to the Government have already shed these perpetual bonds.

Raising capital through other avenues such as equity hurts the return on equity. With the introduction of Basel II norms, Indian banks will need additional capital of up to Rs 60,000 crore to maintain their capital adequacy ratios in the next five years, according to the Finance Minister.

Who will invest in them?

They are an attractive option to long-term investors such as provident funds and insurance companies. In a bid to improve return on investments, provident funds (PF) and insurance companies have begun parking funds in perpetual bonds floated by banks.

Have any Indian banks raised perpetual bonds?

Two banks have recently issued perpetual bonds in Indian Rupees — Indian Overseas Bank and UCO Bank. IOB in March 2006 raised Rs 200 crore through an issue of `perpetual bonds,' the first bank to use this means of funding. 

 

These bonds carry an interest rate of 9.3 per cent, payable every half year. Darashaw & Co, a Mumbai-based securities firm, had invested Rs 200 crore in Indian Overseas Bank (IOB), picking up the entire offering of perpetual bonds issued.

UCO Bank raised capital to the tune of Rs. 230 crore by issuing Innovative Perpetual Debt Instruments ranking for tier -I capital and another amount of Rs. 500 crore by issuance of bonds ranking for upper tier -II Capital during the quarter ended 30.6.2006. 

 

In both cases, the bulk of the subscribers were insurers and provident funds.

Which is the first Indian bank to raise perpetual bonds (qualifying as Tier II capital) overseas?

UTI Bank becomes the first Indian Bank to successfully issue Foreign Currency Hybrid Capital in the International Market. These instruments are qualified as upper tier II capital. UTI Bank Ltd had announced that the Bank raised USD150 million of 15-year subordinated Upper Tier II bonds in the international market on August 04, 2006.  

 

 These bonds are priced with a fixed rate coupon of 7.25%, equivalent to a spread of 231.5 basis points over the 10-year US Treasury, or a yield of 7.273%. This is equal to around Libor plus 170 basis points.

 Which is the first Indian bank to raise perpetual bonds (qualifying as Tier I capital) overseas?

ICICI Bank Ltd had announced that on August 17, 2006, the Bank successfully priced the first-ever foreign currency perpetual non-cumulative subordinated debt securities offering qualifying as Tier I capital by an Indian bank.

Through this issue, the bank raised USD340 million (almost Rs 1,600 crore) at a coupon of 7.25 per cent. The pricing is at a spread of 194 basis points over London Interbank offered rate (Libor), translating into a spread of 247 basis points over 10-year US treasury bond. 

 

These perpetual securities are redeemable at the option of ICICI bank after 10 years with prior approval of RBI, says the offer document. After 10 years, the bank would have to pay a 1% higher coupon rate on the bonds. 

 

It also has a call option after 10 years on every coupon payment. The coupon payments before 10 years is semi-annual, while subsequently it would be quarterly. The bonds are in the nature of hybrid debt, having some features of equities, in that they have no maturity. The bonds are listed in Singapore.

What are the risks for investors?

Banks, Reserve Bank of India, institutional investors - all agree that perpetual bonds carry bigger risk, for investors, than subordinated bonds. But that has not stopped credit rating agencies from offering hybrid capital the same rating as that for subordinated debt issued by the banks.

RBI has put a caveat that such hybrid securities will cease to provide returns if the issuing bank's CRAR falls below regulatory requirements (at present nine per cent). This makes perpetual debt instruments a risky option for investors, particularly in those banks where the CRAR is at lower levels.

What is thus, prima facie palpable is the fact that the 'innovative' instruments hold good only for those banks that have a high credit rating and good asset quality. 

 

Else, convincing investors about the security of their capital or garnering the perpetual debts at feasible interest rates will prove to be a complex barrier for banks' capital expansion. 

 

The RBI evidently has thus ensured that while deserving banks have sufficient leeway to fund their growth, the inept ones either shape up or ship out, aver some analysts.

Are there any tax incentives?

As of now, these perpetual bonds do not carry any tax incentives.

Whether banks will be able to increase shareholder value through the issue of fresh capital/debt?

This is a debatable issue. Bankers argue that they require new capital as they are expanding their balance sheets. However, some industry watchers are doubtful whether banks are optimizing their existing resources. 

 

The important point to note here is whether banks will be able to raise their return on equity, after taking into account the cost of new capital. Only time will tell whether banks will increase shareholder value.

RBI GUIDELINES: NEW CAPITAL RAISING OPTIONS FOR BANKS

BACKGROUND:

With a view to allowing banks to raise additional options for raising capital funds (in Indian Rupees), to meet both the increasing business requirements as well as the Basel II requirements, in January 2006, Reserve Bank of India had permitted banks to augment their capital funds by issue of the following additional instruments:

1. Innovative Perpetual Debt Instruments (IPDI)-Tier I capital
2. Debt capital instruments-Upper Tier II capital
3. Perpetual non-cumulative preference shares-Tier I capital
4. Redeemable cumulative preference shares-Tier II capital

Note: Subsequently, on July 21, 2006 the banks were permitted to raise this capital in foreign currency too.

RBI GUIDELINES FOR Innovative Perpetual Debt Instruments (IPDI)-Tier I capital:

a) These instruments shall not exceed 15 per cent of total Tier I capital.

b) These innovative instruments’ maturity period shall be perpetual.

c) Rate of interest may be either at a fixed rate or at a floating rate referenced to a market determined rupee interest benchmark rate.

d) These shall not be issued with a ‘put option’. However, banks may issue them with a call option subject to:

             

            i. Call option may be exercised after the IPDI has run for at least 10 years

            ii. Call option shall be exercised only with the prior approval of RBI

 

e) Lock-in Clause: The bank shall not be liable to pay interest, if the bank’s CRAR is below the minimum regulatory requirement (at preset nine per cent).

f) Seniority of claim: The claims of the investors shall be superior to the claims of investors in equity shares; and subordinated to the claims of all other creditors.

g) IPDI should be fully paid-up, unsecured and free of any restrictive clauses.

h)  The total amount raised by a bank through IPDI shall not be reckoned as liability for calculation of net demand and time liability for the purpose of reserve requirements and, as such, will not attract CRR/SLR requirements.

i)  Bank’s investments in IPDI issued by other banks/financial institutions will attract a 100 per cent risk weight for capital adequacy purposes.

j)  Banks should not grant advances against the security of the IPDI issued by them.

RBI GUIDELINES for Debt capital instruments-Upper Tier II Capital:

a) Upper Tier II instruments along with the other components of Tier II capital shall not exceed 100 per cent of Tier I capital.

b) The Upper Tier II instruments shall have a minimum maturity of 15 years.

c) Rate of interest may be either at a fixed rate or at a floating rate referenced to a market determined rupee interest benchmark rate.

d) These shall not be issued with a ‘put option’. However, banks may issue them with a call option subject to:

              

              i. Call option may be exercised after the Upper Tier II instrument has run for at least 10 years

               ii.Call option shall be exercised only with the prior approval of RBI

 

e) Lock-in Clause: The bank shall not be liable to pay either interest or principal, even at maturity, if the bank’s CRAR is below the minimum regulatory requirement (at preset nine per cent).

f)  Seniority of claim: The claims of investors in Upper Tier II instruments shall be superior to the claims of Tier I capital instruments; and subordinate to the claims of all other creditors.

g) Upper Tier II instruments should be fully paid-up, unsecured and free of any restrictive clauses.

h) The total amount raised by a bank through Upper Tier II instruments shall be reckoned as liability for calculation of net demand and time liabilities for the purpose of reserve requirements and, as such, will attract CRR/SLR requirements.

i) Banks should not grant advances against the security of the Upper Tier II instruments issued by them.

Note: RBI is yet to issue guidelines for raising capital through the other two modes, namely: Perpetual non-cumulative preference shares-Tier I capital; and Redeemable cumulative preference shares-Tier II capital. 

 

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RELATED TERMS

Subordinated bonds:  A subordinated bond is a bond that has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy. In case of liquidation, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, and so on. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher.

Subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.

The seniority of a bank’s liability determines the stage at which the creditor gets repaid if the bank were to be liquidated. Deposit holders and lenders get first priority followed by holders of subordinated debt. It is only after meeting these liabilities that holders of hybrid instruments would get their dues. Equity holders are at the bottom of the priority list and get paid only if there is anything left over after paying all these investors. Logically, a subordinated debt instrument issued by a bank should be rated lower than a regular bond or deposit. However, as a practice, the rating agencies have matched the rating of ordinary bonds while issuing ratings to subordinate debt.

HYBRID CAPITAL:

             Hybrid capital combines features of both debt and equity. Like debt, hybrid capital does not dilute the ownership of existing shareholders, and is often structured to provide tax-deductible payments. Like equity, hybrid capital absorbs operating losses and is subordinated to depositors and senior debt holders in the event of default. They are hybrids in the sense that they incorporate both debt and equity features. The instruments are constructed to maximize benefits of both debt- and equity holders.

Hybrid capital combines characteristics of both debt and equity and it has been recognised by the Bank for International Settlements (BIS) as a form of bank capital since 1988. According to the BIS guidelines, hybrid capital instruments can be a part of Tier I (through an instrument called Hybrid Tier 1) or Tier II (Upper Tier II). Tier I is a bank’s core capital whereas the latter is the supplementary capital that includes undisclosed reserves and subordinated debt.

TIER I CAPITAL:

According to Basel Capital Accord 1988, it comprises:

• Permanent shareholders’ equity
• Disclosed reserves
• Perpetual non-cumulative preference shares
• Innovative capital instruments

TIER II CAPITAL:

According to Basel Capital Accord 1988, it comprises:

• Undisclosed reserves
• Revaluation reserves
• General provisions/general loan-loss reserves
• Hybrid debt capital instruments
• Subordinated term debt

LOWER TIER II CAPITAL:

In general, this comprises:

• subordinated debt with a term of at least five years; and
• redeemable preference shares which may not be redeemed for at least 5 years.

Note: The remaining components of Tier II capital may be construed as Upper Tier II capital

TIER III CAPITAL:

According to Basel Capital Accord 1988, it comprises:

• It is short term in nature
• It is an optional item of capital
• It is for meeting a portion of banks’ exposure to market risk
• RBI, as of now, does not allow banks to raise capital under Tier III.