In today’s Finshots, we explain how an exotic financial instrument called a perpetual bond is coming back to haunt Yes Bank’s dreams.
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When a bank needs money, it has a few options on the table.
- It could borrow money by raising deposits from its customers. You know, the Fixed Deposit kind. That’s the traditional way to do it.
- It can issue bonds to the public. The bank will pay interest on these bonds. And it promises full repayment on a specific date. It’s like a Fixed Deposit (Remember this statement okay?).
- It could issue new shares to investors. But it means that ownership gets diluted. If the owner of the bank held 1 out of every 100 shares before, now they might only have 1 out of every 110 shares. And some people don’t like losing ownership.
Now in the case of Fixed Deposits and bonds, banks have to return the money at the end of the promised period. The money has a limited shelf-life. But equity money doesn’t come with such strings attached. The bank gets to keep the money basically forever.
So some finance geeks sat around a table and thought, “What if we could create something fabulous that combines the features of bonds and equity shares? We could pay interest to the investor like in a regular bond. But we get to keep the money forever like equity.”
And voila, perpetual bonds were born.
Banks loved it. Since they didn’t really have to return the money, they could simply add it to their long-term capital buffer. It could shore up their reserves. They called it an Additional Tier 1 or AT1 bond. And it comes in handy in case of an emergency or a financial crisis. The bank can dip into its reserves and keep running smoothly.
All good so far?
Anyway, the basic premise when someone invests in an FD or bond is that it’s safe. And the rules of the game say that if a company is failing, it’ll sell off any remaining assets and pay the lender first. Lenders being FD and bond investors. They get protection.
On the other hand, an equity (stock) investor is treated differently. They’re considered a part owner. When the bank does well, they have an unlimited upside — the share price can zoom and give them a windfall or they can earn dividends. Unlike bond and FD folks who only get a consistent interest rate even if the bank earns supernormal profits. So, if equity investors get an outsized upside, it’s only fair they take the hit on the downside. That means if the bank fails, they get wiped out. No one’s going to feel sorry for them and say, “Oh, you poor equity investor. Here’s some money we got from the assets we sold.”
But, here’s the thing. These perpetual bonds are a hybrid creation. They’ve got both debt and equity characteristics. They pay interest like a regular bond. However…if the bank is struggling and on the brink of a catastrophic failure, then it can ignore these perpetual bond investors. It need not pay them back. It can write off its perpetual bonds. The investors get nothing. Zilch. Nada. It’s nothing like a Fixed Deposit!
Crazy, right? All that talk about bonds being safe gets thrown in the bin when it comes down to the business of perpetual bonds.
And this finally brings us to Yes Bank.
See, in 2020, the bank ran into trouble. People and corporates it lent money to were defaulting. Bad loans were soaring. And Yes Bank was on the brink of a catastrophic failure. Everyone thought the bank would go belly up.
But its peers stepped in and rescued it. SBI and seven other Indian banks took a combined stake of 79% in Yes Bank. The bank even issued new equity shares at a massive discount and raised more money.
FD holders were saved. Bond investors were cocooned. Even equity shareholders were protected.
But the one who invested in perpetual bonds thinking they were as safe as houses? They got the short end of the stick. They lost everything. Over ₹8,000 crores worth of these perps were wiped out completely.
Naturally, many of these investors were livid. They were just regular folks; senior citizens who didn’t know squat about the murky world of finance. They complained that Yes Bank’s own staff members had sold them these perps. They were fooled into believing that their investments were as safe as FDs.
Yes, with FDs the bank is expected to return the principal at the end of the term. With perpetual bonds, they don’t have to return the principal. However, banks do extend a call option where they can redeem the bond and return the principal at their discretion. So you could still sell these as alternatives to Fixed Deposits or even better, rebrand and call them super-fixed deposits instead. Which is apparently what some Yes Bank employees did back in the day.
Eventually though, the bank failed, the bonds were written off and the super fixed deposit just disappeared into thin air. It wasn’t super. It wasn’t fixed.
Needless to say, aggrieved customers took the matter to court.
And after a bit of back and forth, this is what the Bombay High Court said on Friday. We’re paraphrasing what the court said to make it simpler, okay?
So the RBI put together a preliminary plan to save the bank. In the plan, it said that the bank was going to write off these perpetual bonds. But people naturally raised objections. So the RBI modified the plan and deleted the clause. It submitted this new plan to the government. The government read it thoroughly and gave it the green light.
That means, the final plan did not say anything about writing off these perpetual bonds. So, how could the person in charge of executing this plan randomly decide to write off the bonds? It’s a clear lapse in operating procedures.
The end result?
Yes Bank might have to bring back the perpetual bonds from their grave.
And that’s getting a few other people worried. See, the bank was just beginning to look well.. It had cleaned up its act and things were looking up. But now this?
So naturally, the question on everyone’s mind is — will Yes Bank have to pay their investors the full ₹8,000 crores?
Well, maybe not!
Wait…but didn’t the court just order that?
Not really. Because here’s the thing. If you read the order, you’ll find that the High Court isn’t saying how perpetual bonds should typically be treated — complete write-off, haircut, conversion into equity; that’s not the question in hand. It’s not even talking about the misselling of perpetual bonds. The court only said that at least in the case of Yes Bank, the final decision-making process to write off the bonds was flawed.
That means Yes Bank could simply follow the order and bring these perpetual bonds back to life. Include the bonds as part of its capital. And then turn around and say, “Sure, we’ve brought these bonds back. But we’re not going to pay any interest on these bonds. We’re also within our rights to keep the money with us forever because the terms and conditions state that we are not obligated to pay anything if the bank fails. Which it did, a few years ago! Sorry, but that’s just how these things work.”
So yeah, maybe the order won’t really hurt Yes Bank. It’ll keep the money. And the perpetual bondholders will likely still be left holding the bag wondering what the future has in store!
A really terrible situation for those poor customers.
PS: Here’s something interesting. Mr Prashant Kumar was the ‘administrator’ who was appointed by the RBI to restructure Yes Bank in 2020. He’s the one who carried out this exercise of writing off the perps. And then, after the deed was done, he became the CEO of the revived Yes Bank. Yup, the one who killed the bonds is now the CEO in charge of decision-making. Hmmm…
Ditto Insights: Why Millennials should buy a term plan
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So why is this happening?
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There’s another reason why millennials should probably consider looking at a term plan — Debt. Most people we spoke to have home loans, education loans and other personal loans with a considerable interest burden. In their absence, this burden would shift to their dependents. It’s not something most people think of, but it happens all the time.
Finally, you actually get a pretty good bargain on term insurance prices when you’re younger. The idea is to pay a nominal sum every year (something that won’t burn your pocket) to protect your dependents in the event of your untimely demise. And this fee is lowest when you’re young.
So if you’re a millennial and you’re reading this, maybe you should reconsider buying a term plan. And don’t forget to talk to us at Ditto while you’re at it.
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