Market regulator Securities and Exchange Board of India, or SEBI, has tightened the investment norms for debt funds. From April 1, 2021, no fund company can hold more than 10% of any single issuer issuing instruments having special features such as subordination to equity (absorbs losses before equity capital) and/or convertible to equity upon trigger of a pre-specified event for loss absorption under all its schemes.
Additional Tier I bonds and Tier 2 tend to have such special features. The debt instruments having such special features, which otherwise are Non-Convertible Debentures, have to be treated as debt instruments until converted to equity, said SEBI.
At the scheme level, no fund shall hold more than 10% of its NAV of the debt portfolio in such instruments and not more than 5% of its NAV issued by a single issuer.
In response to SEBI’s diktat, The Ministry of Finance through a memorandum has requested SEBI to withdraw a provision of its circular to value perpetual bonds at 100 years. The Ministry 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 and thereby result in higher borrowing costs for banks at a time when the economy is still trying to recover from the throes of pandemic. As per MOF, mutual funds currently hold more than 35,000 crore of the outstanding AT1 issuances of Rs 90,000 crore.
Meanwhile, the Association of Mutual Funds in India, or AMFI, said that it is in discussion with SEBI to further smoothen the process of implementation of this circular. It said that most mutual fund schemes are well below the 10% cap specified in the circular.
If any scheme exceeds the cap mentioned above, they are not allowed to make any fresh investment in such instruments. Funds that have exceeded this cap are allowed to grandfather the portion of exposure above 10%, which means they are exempted from the new rule till these bonds mature. The provisions of this circular come into effect from April 1, 2021.
The industry has Rs 39,098 crore worth of exposure to AT1 and perpetual bonds issued by 22 firms, mostly banks. Of this, 23 schemes hold more than 10% each in AT1 and perpetual bonds combined issued by different banks. Banks raise money through AT 1 bonds while corporates issue perpetual bonds. State Bank of India, Axis Bank and ICICI Bank are the largest issuers of AT1 bonds. These three banks combined have raised worth Rs 17,642 crore from AT1 bonds through mutual funds.
Here are 22 funds that have over 10% exposure to AT1 and perpetual bonds as on February 2021.
AMCs which have the highest exposure to AT1 bonds and perpetual bonds in terms of value.
Categories like Banking and PSU, Dynamic Bonds, Dynamic Asset Allocation Funds and Credit Risk Funds have exposure to AT1 bonds.
Fund officials say that the cap on exposure limit could result in selling off such instruments but currently, there are limited or no buyers for the same. They are awaiting clarity from SEBI on the future course of action. If we look at the portfolios of schemes that hold such bonds, some bonds are either thinly traded or non-traded securities. These instruments are denoted by the signs in the portfolio which mean:
- T** -> Thinly traded securities
- N** -> Non traded securities
What are perpetual or Additional Tier 1 Bonds?
Additional Tier 1 Bonds are also known as perpetual bonds. AT1 bonds are issued by banks without any maturity date but they have a call option. Banks issue AT1 bonds to meet their capital adequacy requirement. Higher capital adequacy norms came into force after the 2008 financial crisis with the collapse of few banks and financial institutions.
Banks can skip paying interest or principal if the bank’s capital adequacy ratio falls below a certain threshold. They 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 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.
Do note that perpetual bonds carry credit risk, interest rate risk and liquidity risk.
- Credit Risk: The issuer has the option to write off the principal in times of severe financial stress.
- Interest Rate Risk: Since they are perpetual bonds with no defined maturity, you may earn less interest especially when rates are rising. You could have invested that principal in higher-yielding instruments.
- Liquidity Risk: 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 have the option of selling these bonds in the secondary market but you may have to exit at a loss as the bond’s price may differ from what you paid. Also, some of these are bonds are thinly traded, which means there are limited buyers.
A case in point is Yes Bank which had written-off its perpetual bonds worth Rs 8,700 crore by invoking a statutory clause provided by the central bank. The Reserve Bank of India, or RBI, had invoked Point of Non-Viability, or PONV, trigger due to which investors suffered loss of principal. PONV is a point at which the bank may no longer remain a going concern on its own unless appropriate measures are taken to revive its operations. These bonds have loss-absorbing capacity through conversion to equity/write-off/write down, on breach of pre-specified trigger point and at the point of non-viability. Such bonds were sold to gullible investors with the lure of higher than fixed deposit return and investors lost their principal. Thus, such bonds can be riskier than equities.
The perpetual bond market is reasonably active with regular trades in large and higher rated issuances. Most trades in perpetual bonds happen on a yield-to-call basis. Yield to call is the price that will be paid if the issuer redeems the bonds early. This is based on the established market convention, locally as well as globally, that the issuer will exercise the call option on the due date.
“Perpetual bond market sees active participation from various players viz. banks, corporates, mutual funds and individual investors. Only in the event of lack of traded prices, the question arises as to whether the bond should be valued to call or to maturity. Given a reasonably active market with regular trades, the issue is narrower than it appears,” says AMFI.
The industry body has requested investors not to panic about their schemes having exposure to these instruments. “While in the short-term prices can be influenced by many factors, in the long-term fundamentals will prevail. Past experience does suggest that Investors have benefitted from ignoring short term volatility.”
(Data Source: Morningstar Direct.)