Monday, November 06, 2006

Perpetual bonds: the developing controversy

Perpetual bond is a hybrid instrument that pays interest forever. It belongs to the same category as that of an equity share. This instrument made its entry into the financial markets last year. The issuers of perpetual bonds are primarily Scheduled Commercial Banks. In January, RBI allowed banks to shore up their capital through issuance of perpetual bonds and another instrument called upper tier II bond.

So far about Rs. 2,000 cr worth of perpetual bonds are issued by various banks. Cooperative banks are not allowed to subscribe to these bonds.

But brokers who are associated with issuance of these bonds, are conniving with some of the cooperative banks in Maharashtra and making the latter buy these bonds and hold them for some time – usually a couple of months, i.e., till January. By that time they are expecting the provident funds (to whom they expect to offload these bonds) to be flush with cash flows on account of interest receipts from government’s special deposit scheme. That is when the brokers expect to buy these bonds from the cooperatives and sell them to the PFs making a neat profit.

For these two months, the cooperative banks’ books show these investments wrongly as investments in ordinary corporate bonds, since a perpetual bond has a call option at the end of 10 years, in the banks’ portfolio it will appear like any other corporate bond with a fixed interest coupon, maturing in 2016. So even after they have done a thing which should not have been done in the first place, these banks can still escape the glare of auditors, because the year-end statements will not reveal the true character of these bonds in view of their squaring up of the transactions before the close of the accounting year.