SEBI's AT1 bonds' rule resolved: Should you hold or sell your debt funds?

The Securities and Exchange Board of India (SEBI) issued a circular on Monday, postponing the 100-year maturity rule for valuing perpetual bonds by two years.

This clarification by SEBI came after the finance ministry raised concerns that this rule would cause panic redemptions from mutual funds on the back of a drop in net asset values (NAV) if Additional Tier 1 (AT1) bonds are valued as 100-year securities. The finance ministry has also observed that if mutual funds are discouraged from buying AT1 bonds, then the market for these securities would dry up and it would be difficult for banks, especially public-sector banks, to raise capital.

SEBI’s original ruling and the March 22 clarification cover Tier-2 bonds as well. This settles the uncertainty that had debt mutual funds in a bind. The regulator has not relaxed the rules. But it has given more time to mutual funds for adapting to the new rules.

A graded approach

The new rules say that MFs will have to value these bonds as ten-year papers to begin with, gradually increasing the maturity and valuing them as 100-year instruments from April 1, 2023.

MF experts say the changes in rules will ease the impact on debt schemes for now. But funds are less likely to invest in such bonds in the long-run.

“For now, valuation of these bonds in MF schemes may fluctuate less than what was apprehended, but gradually MFs will reduce exposure to these bonds as price volatility will rise at 20-30-year maturities,” says Joydeep Sen, corporate trainer-debt market.

MFs had feared that valuing these bonds as 100-year papers with effect from April 1 this year would cause yields of these bonds to spike, and impact the NAVs of the debt schemes. Rising yields cause bond prices to fall.

If there were no trades in a perpetual bond on a given day, MFs will have to value it according to the 100-year rule in absence of any price discovery.

Lakshmi Iyer, head-fixed income and products at Kotak Mahindra mutual fund says that this shouldn’t be a problem. “Most of the bonds are traded quite frequently. There could be some exceptions here and there.”

Experts says SEBI has advised the Association of Mutual Funds in India (AMFI) to come out with a detailed guideline on how such bonds need to be valued.

Also read: Mutual funds plan to approach SEBI to relax rule on perpetual bonds

Why are MFs important for the perpetual bond market?

MFs are among the largest investors in the perpetual bonds and hold more than Rs 35,000 crore worth of AT-1 issuances, of the Rs 90,000 crore outstanding.
According to a Moneycontrol analysis of data provided by CRISIL, around Rs 63,700 crore of assets are invested in such AT1 and T2 bonds, across 21 categories – most of them are held by debt and hybrid funds. Medium duration (11.1 percent of the category’s total assets lie in AT1 and T2 bonds), Banking & PSU debt (10.5 percent) and credit risk funds (9.4 percent) are the ones that hold these bonds the most.

Fearing that PSU banks will find it difficult to raise capital if MFs start to shun these bonds, the Finance Ministry had advised SEBI to withdraw the rule. “Knowing that from April 1, 2023, these bonds would need to be valued as 100-year papers, MFs will be selective about which of their schemes would hold securities with such interest-rate sensitivity,” says Kaustubh Belapurkar, director-manager research, Morningstar India. He also adds that since the tenure of such securities can be taken as 100 years, shorter tenure funds would be constrained while investing in them.

If your fund is risky, then say so

In its earlier circular (March 10, 2021), SEBI had stated that it wanted to change how mutual funds treat debt instruments that carry higher risks than other bonds.

When debt funds invest in a security, they expect to earn an interest income throughout the instrument’s tenure. The principal amount is paid at maturity. If the organisation goes bankrupt or gets into financial trouble, priority must be given to debt funds in paying the dues. But not all instruments are at the same priority level when the borrowing firm needs to repay its creditors.

Also read: AT1 and Tier 2 bonds may not be too risky for debt funds, but SEBI is taking no chances

Holders of AT1 bonds come last in the queue after bank depositors, general and other creditors in the payment of dues if the firm goes bankrupt. There have also been cases where AT1 bonds have been completely written-off by the bank, under directions of Reserve Bank of India.

Also read: Explained: The impact of Yes Bank’s AT1 bonds on debt fund investors

AT1 bonds, which are issued by banks for raising capital, have no fixed maturity dates. Hence, these are called as perpetual bonds.

These bonds have a call option that gives the bond issuer right to terminate the bond and return money to bondholders. However, if the bank decides not to exercise the call option on the call date and rolls it over, the debt MF holding the bond will not have much of a choice.

Should you withdraw from MF schemes or stay invested? 

Financial advisors say investors should not withdraw their investments from MF schemes immediately, unless their schemes have highly concentrated investments in AT-1 and Tier-2 bonds of weaker banks.

“If the scheme is largely invested in bonds of good-quality banks such as State Bank of India , the impact will be lower. To some extent, bond markets have factored in the impact on yields for a year for valuation at 10-year maturity,” says Deepak Chhabria, chief executive officer and director at Axiom Financial Services.

If you remained invested for over three years and your scheme has large investments in AT1 and Tier-2 bonds of weaker banks, you can exit in April, 2021, which will make you applicable for long-term capital gains tax of 20 percent post-indexation.

Later, you can re-invest into another fund, which has little or no investments in such bonds.

Kirtan Shah, chief financial planner at SRE, says a scheme with over 10 percent of its holdings in such bonds can be a cause of concern, as changes in bond prices will have a large impact on the scheme's NAV.

More clarity will emerge once AMFI shares valuation guidelines that MFs will need to follow.