How will Sebi’s perpetual bond rules impact mutual funds?

This article was originally published on this site

Last week Sebi asked MFs to treat perpetual bonds as if they have a maturity of 100 years. It also capped exposure to such bonds at 10% of scheme assets. The MF industry has raised concerns that this rule may depress the valuation of such bonds, lower NAVs. Mint explains:

What are additional Tier 1 or AT-1 bonds?

Additional Tier 1 (AT-1) bonds are issued by banks in order to absorb losses in case of erosion of their capital. For instance, if non-performing assets (NPAs) threaten a bank’s financial viability, AT1 bonds will bear losses before ordinary bond-holders or depositors are hit. These bonds have no maturity date. However, banks can repay them at certain “call dates” without having any obligation to repay on those dates. Though Indian banks have historically not skipped on call dates, there are exceptions. One famous example of AT1 bonds not being repaid is the Yes Bank failure in 2020.

What is the problem with AT-1 bonds?

AT-1 or perpetual bonds are traditionally valued at price-to-call. This means that mutual funds have valued them as if they would be repaid on the call dates. Such dates are typically set at short intervals of, say, 5 to 10 years, and hence their maturity is set accordingly. A change in valuation to 100-year maturity will greatly increase their sensitivity to interest rate changes and impact the overall duration of the mutual fund portfolio. Such a revaluation could also lower their value and hence reduce the net asset values (NAVs) of the mutual fund scheme holding them, and trigger a flood of redemptions.

View Full Image

Uncertainty ahead

When will the Sebi circular be implemented?

The circular will come into effect on 1 April, 2021. However, industry executives worry that some funds may not wait till then to lower the value of the bonds in their portfolios, to discourage redemptions in anticipation of an NAV shock on 1 April. The department of financial services of the finance ministry and MFs themselves have asked Sebi to withdraw the maturity rule.

What precautions can you take for now?

You should check the exposure of your debt MFs to AT-1 bonds. If you have purchased the bonds via a distributor or bank, ask them to provide this information. As per Crisil, 36 MF schemes hold more than 10% exposure to AT-1 and Tier 2 bonds (another risk-absorbing debt paper issued by banks). Do not take any action in haste. The provision may be withdrawn or diluted following the reaction from the finance ministry and the MF industry. Even if the circular is not withdrawn, the NAV dip may be temporary.

Should you buy if MFs offload AT-1 bonds?

AT1 bonds are a complex product. Individuals who bought AT-1 bonds of Yes Bank before the 2020 crisis saw their money wiped out. In addition, Sebi has stipulated a minimum trading lot size of 1 crore for such bonds, and permitted only qualified institutional buyers (QIBs) to purchase them from banks. For retail individuals, buying these bonds may not be a good idea. Also, note that the banks issuing them have the option but not the obligation of repaying holders of such bonds on the call dates.

Subscribe to Mint Newsletters

* Enter a valid email

* Thank you for subscribing to our newsletter.