Bankers Suggest Revisiting Call Option Valuation For Perpetual Bonds

Indian lenders have proposed that investments in perpetual bonds issued by banks should be valued based on the call option instead of being considered as 100-year securities, said four sources who are familiar with the matter. The current rules have had a negative impact on the demand for such bonds, making it more expensive for banks to raise capital.

"Funding needs for banks will rise and changing the valuation would be beneficial as it will increase the investor base," said JM Financials' Managing Director and Head of the Investment Grade Group, Ajay Manglunia.

The Securities and Exchange Board of India (Sebi) changed the way Additional Tier 1 (AT-1) bonds were valued in March 2021 after Yes Bank completely wrote down such bonds in 2020 as part of a state-led restructuring plan.

The Indian markets regulator had asked mutual funds to value perpetual bonds as 10-year papers until March 2022, 30-year papers until March 2023, and 100-year papers thereafter. However, a recommendation has been made to the National Financial Reporting Authority (NFRA) to revert to the international practice of valuing perpetual bonds as 100-year papers.

A government official, who requested anonymity, stated that the recommendation is under review with the NFRA, which oversees auditing and will submit its views to a panel of top regulators. The change in valuation norms has led to a decline in the issuance of such bonds by Indian lenders to around Rs 137 billion (USD 1.65 billion) in the current fiscal year, down from a peak of Rs 430 billion in 2016-17, according to Icra.

In the beginning of this month, State Bank of India (SBI), the largest lender in the country, raised funds through perpetual bonds. The bonds carry a 10-year call option at a coupon rate of 8.34 per cent, which is around 70 basis points (bps) higher than the 10-year AAA-rated corporate bond yield. Before the Yes Bank episode, the spread between the two used to be around 30 to 40 bps in 2019. Traders suggest that if the norm is changed back to the way it was, spreads may fall to around 50 bps.

Higher spreads mean that investors are demanding more premiums for investing in perpetual bonds, which makes them expensive for banks. Sandeep Bagla, Chief Executive Officer (CEO) of Trust Mutual Fund, said that if the valuation of the bond shifts from deemed 100-year maturity to call option, as is the market practice, mutual funds are likely to invest significantly.