The circular issued by the Securities and Exchange Board of India (Sebi) on March 10 on perpetual bonds has put the mutual fund (MF) industry in a tight spot. Industry insiders say applying the 100-year maturity rule to value perpetual bonds can create volatility in NAVs of mutual fund schemes exposed to such bonds.
The additional tier-1 bonds issued by banks, which are usually perpetual bonds account for around Rs 35,000 crore of mutual fund investments, according to industry estimates.
Sebi’s new rule says that the maturity of all perpetual bonds needs to be treated as 100 years from the date of issuance of the bond for the “purpose of valuation”.
“These securities are usually traded at yield to call rates. However, with the new rule, these bonds will be valued at the higher yield to maturity on non-trade days. This would lead to volatility in the prices of these bonds,” said a fund manager, requesting anonymity.
As higher yield means lower bond prices, investors could see dip in NAVs of the MF schemes exposed to perpetual bonds, when these don’t get traded. The NAVs of schemes would recover when these bonds are traded again at yield to call date.
Yield to call indicates total returns an investor will get if she holds the bond till its next call date, which is the date when the bond issuer can buy the bond back.
“If investors withdraw their funds when these bonds are not traded in the market, they could end up taking a hit on their investments,” said the fund manager.
Perpetual bonds, though continue to exist in perpetuity, come with a call option in many of them. The call option gives the company the right to terminate the bond and return money to bondholders. The Put option gives bondholders option to redeem bonds.
Industry executives say Sebi’s new rule can end up giving an advantage to some investors over others.
“Investors who are more tuned into debt markets may be able to take advantage of price fluctuation of such bonds. On days when there is no trade in these bonds, such investors would invest in MF schemes as prices of these bonds fall, and redeem when trade happens,” another fund manager said, requesting anonymity.
Industry insiders say while Sebi has made the move with the intention of protecting investors, this rule may unnecessarily put investors in a difficult situation.
“Once we make the presentation, we are hopeful the regulator will be open to suggestions and concerns raised by the MF industry, as it has shown in the past,” the second fund manager said.
What are the other changes Sebi wants?
The market regulator has also laid down certain investment limits on perpetual bonds.
Mutual funds should not be investing more than 10 percent of the scheme’s corpus in perpetual bonds, the Sebi circular read.
And the exposure should not be more than five percent to a perpetual bond of the same company.
Sebi has laid down these limits keeping in mind that these bonds come with some loss-absorption features, which can make them risky investments for MF schemes.
The additional tier-I bonds of YES Bank were written down last year, with mutual fund holding over Rs 3,000 crore worth of investments in these bonds. Bondholders, including mutual funds, had approached Bombay High Court on the matter.
In November 2020, the tier-II bonds of Lakshmi Vilas Bank, were written down under the directions of the Reserve Bank of India.
In India, perpetual bonds are usually issued by banks to meet their capital requirements.