Hello and welcome to find shots daily in today's episode, we talk about CBS new perpetual bond norms when immortal bonds become mortal.
The mutual fund industry operates on a simple premise, and you could summarize it like this. Regular investors have little knowhow about the complexities inherent in the stock market. Therefore, a better approach is to let experience fund managers take care of business for you. And while there are many ways professionals can choose to manage your money, the most popular avenue is to create a mutual fund. This way, companies can take your money diverted to a common pool of funds, mobilized from other people like you, and invest this massive karpas in hand-picked stocks to offer you outsized returns.
All this for a small fee. It seems like a Win-Win for everyone involved, but not everybody wants a piece of the Indian stock market and not everybody wants to experience this wild, crazy trip. The ups and downs can be too much. It's never a good feeling to hear that your fund is down 10 percent because the stock markets continue to tumble. So for the faint hearted, they offer another alternative, a debt mutual fund. This time they will use your money to lend to corporates and governments instead of buying stocks from select companies.
In return, the corporate will promise to pay the fund house the entire principle within a specified timeframe and a fixed sum on top. The contract agreement is called a bond. The time frame, it's called the maturity period. And the fixed return on top is called the yield. That's the basics covered. Anyway, if you are following an explanation so far, you should already see how these debt mutual funds might suit some investors. Unlike equity mutual funds, where the fund house is exposed to the swings of the market, that mutual fund offers more consistent returns.
Ergo, once a fund house invest in a bond, the corporate is liable to pay back the principal and the yield in full feeling, which the fund house can drag the culprit to bankruptcy court. So most corporates are likely to honor their obligation. And at this point we can safely introduce the stock cost of this story. Perpetual Bonds and EIGHTY-ONE Bonds. Perpetual bonds don't have a fixed majority, so there's no obligation for the borrower to pay back the principal and that extra yield on top level.
But this poses an interesting question. Why are perpetual bonds what anything if the borrower isn't obligated to return the money? It's a nice point, but alas, there's a rather simple answer. Perpetual's might not offer you the principal, but they do offer periodic interest. This is what gives them value. And the EIGHTY-ONE Bond central to the story is a perpetual. So let's start looking at this bad boy. For starters, banks issued these bonds in a bid to raise money and cushion their coffers.
It is to make sure that these institutions have enough cash to stave off a crisis. However, back when one bonds were originally introduced, they ran into a lot of tacos. Nobody was willing to lend money in return for one of these bonds, which is when banks were forced to add a call option alongside these instruments. This option. I love the banks to prepay investors before maturity. The norm was set at five or ten years, meaning lenders could now expect to see their money at some fixed date in the future.
It didn't feel like a perpetual waiting exercise, however. Once again, there was no obligation for the bank to trigger the call option or return the money. It was still at the bank's discretion. More importantly, they could even skip making the interest payment if they fail to turn a profit. So by all measures, these bonds were risky as hell and then things got worse. When, yes bank was crumbling under pressure, the RBI intervened, assumed full control of the bank and brokered a bailout following which all yes bank eighty one bonds were written off.
This meant the bank no longer had an obligation to pay the interest on exercise the call option.
For all practical purposes, the bonds were deemed cancelled and they were pronounced worthless. It was a sad ending, but one that sent alarm bells ringing all across the board. Several mutual fund houses held boatloads of these bonds and marketed their schemes as being safe and secure to prove their point. They would also show how most bonds in the scheme came with short maturity periods. Think of it this way. If bonds held by a mutual fund house were expected to mature in three months, that would give people a lot of confidence.
After all, the likelihood of things going south over such a small period is rather negligible. It is safe to assume you would receive your money in full. But what happens when you add EIGHTY-ONE Bonds to the mix? Well, if you have a scheme with bonds that on average matured in six months, adding a single bond with the term lasting. Forever would take the average to infinity and beyond, it would make the whole scheme a perpetual, but usually that is not how we do things.
And with 81 bonds, fund houses kept using the call option as a get out of jail card, they would assume the bonds would match in five or 10 years when the options were due. And to be fair to these people, it's what the market assumes as well. Most banks do exercise the call option because if they don't, every investor out there will automatically assume the bank is in deep trouble. Why isn't the bank paying back? Is the bank running out of cash?
Will it fail? There will be speculation and it will destroy any institution. So it makes sense to assume that these EIGHTY-ONE bonds would mature with the exercising of the call option. However, accounting for it this way gives mutual fund investors a false sense of security. They don't know about Perpetual's and the risk associated with them. So the regulator had to intervene. And a few days back, Sebi made some big changes. For starters, fund houses that promised investors that their schemes only hold bonds that mature in a certain fixed period can no longer buy into these 81 bonds.
Even others are expected to limit their exposure to 10 percent, meaning these bonds can make up more than 10 percent of their portfolio. These are, by all accounts, much needed changes. But there was one other bet that ruffled a lot of feathers. Sebi also mandated fund houses to value these perpetual bonds as if they would mature in a hundred years. And that changes a lot of things. Think about it. Until now, they would value these bonds as if they would mature in five or 10 years.
They believed they would receive their money in that time frame. But now if they are told by Sebi to change that worldview, they would have to assume that they'd only receive their money 100 years later. Imagine waiting a hundred years. That's as good as never seeing your money. And if you were the mutual fund house, we ask you this. Would the bonds still be as valuable to you know, they wouldn't. In fact, regulations would mandate you to reconsider your valuation.
So the value of these bonds and the value of their funds could possibly plummet overnight. This could trigger a panic way with investors choosing to redeem their funds en masse, which could then put the whole fund house at risk. So soon after we released its circular, the finance ministry intervened, asking the regulator to reconsider this last point. Once again, bear in mind, fund houses are very happy to value these bonds based on their existing worldview. In fact, when these bonds exchange hands, which is rare, they are still valued as if they would mature in five or 10 years alongside the call option.
But Sebi wants everyone to look at it differently, and it's making a lot of people sweat. That's it. That's the story. And while it is extremely complicated, we try to simplify it as much as we could. We might also have bought the line and oversimplified a few things. So thank you for sharing with us. And if you found this account useful, don't forget to share this podcast episode with your friends, family and colleagues.
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