So what are perpetual or AT1 Bonds? And what all do we need to know..

There's a lot of buzz going around about the Ministry of Finance (through a memorandum) requesting SEBI to withdraw a provision of its circular to value perpetual bonds at 100 years. 

The MoF cited that there is currently no benchmark for valuing perpetual bonds at 100 years and the move could result in mark-to-market losses, panic redemptions in debt markets. 

So what are perpetual or AT1 Bonds? And what all do we need to know.. 

AT1 bonds/Additional Tier 1 Bonds are also known as perpetual bonds. These bonds are issued by banks without any maturity date but have a call option. Banks issue AT1 bonds to meet their capital adequacy requirement. After the 2008 financial crisis, higher capital adequacy norms came into force with the collapse of few banks and financial institutions. 

 Banks need to maintain capital adequacy ratio of 10.875% and a Capital Conservation Buffer of 1.875% to protect themselves from any systemic risk. Banks aim to keep their capital adequacy ratio above this regulatory limit. 

Perpetual bonds comes into picture here..

Perpetual bonds do not come with any specified maturity, but they can be redeemed by issuers, usually after five years or ten years. The issuer may call or redeem the bonds if they can refinance the issue at a cheaper rate, especially when interest rates are declining. They also have the option to keep paying you interest or skip and extend the tenure of bond.

Perpetual bonds carry credit risk, interest rate risk and liquidity risk.

1. The issuer has the option to write off the principal in times of severe financial stress. So, Credit Risk

2. Since perpetual bonds have no defined maturity, you may earn less interest especially when rates are rising. You could have invested that principal in higher-yielding instruments. Here comes interest rate risk

3. There is no surety that you will get your principal back on the call date as the bank may choose to extend the tenure of bonds at a future date. You'll be left with the option of selling these bonds in the secondary market but may have to exit at a loss as the bond’s price may differ from what you paid. Also, some of these bonds are highly illiquid as they have very limited buyers. Finally Liquidity risk.