On March 10, the capital markets’ regulator, the Securities and Exchange Board of India (SEBI), issued a circular aimed at mutual funds (MFs). The SEBI circular intended to review investment norms for MFs regarding investment in debt instruments with special features, and the valuation of perpetual bonds.
SEBI’s circular on MFs which comes almost a year after the crisis at YES Bank—when the troubled private sector lender underwent a moratorium, which was soon followed by a newer set of investors replacing the bank’s founding promoters—looks well thought out and in investors’ interests.
In its circular, which is slated to take effect from April 1, SEBI explained that MFs invest in debt instruments with special features, like subordination to equity, whereby the investors in such instruments have to bear losses before equity capital investors, and in some cases the debt investment could also get converted to equity upon the triggering of a pre–specified event to absorb losses.
Additional tier 1 (AT1) and tier 2 (AT2) bonds, issued primarily by banks, are the debt instruments with the special features referred to above. In the case of YES Bank’s bailout, the banking regulator—the Reserve Bank of India (RBI)—had decided that AT1 bonds would be written–off in order to ensure that the capital infused by a host of banks led by State Bank of India (SBI) was not diluted to cover liability.
As a result, YES Bank’s AT1 bond investors had to bear a knock–off of ₹8,400 crore. Similarly, later in 2020 when Tamil Nadu-based Lakshmi Vilas Bank was bailed out by DBS Bank India—a subsidiary of Development Bank of Singapore—investors in AT2 bonds of the troubled private lender had to bear losses worth over ₹320 crore. According to a March 12 report from Nomura, at a system level the outstanding AT1 and AT2 bonds are expected to be in the range of nearly ₹3.5 lakh crore, of which MFs have a sizable share, amounting to nearly 19%.
Coming back to SEBI, the March 10 circular noted that “presently there are no specified investment limits for these instruments with special features and these instruments may be riskier than other debt instruments.” Hence, SEBI notified prudential investment limits for such instruments.
According to the new norms, no MFs, under all its schemes, shall own more than 10% of such instruments issued by a single issuer. And, at the individual MF scheme level, investment in such instruments shall not be more than 10% of its net asset value (NAV) of the debt portfolio of the scheme in such instruments; and not more than 5% of its NAV of the debt portfolio of the scheme in such instruments issued by a single issuer.
SEBI also notified that the investments by MF schemes in such special instruments in excess of the newly specified limits may be ‘grandfathered’, and such MF schemes shall not make any fresh investment in such instruments until the investment comes below the specified limits.
Calling SEBI’s directive a risk mitigation measure to reduce portfolio risk in debt MF portfolios, Mumbai–based CRISIL Research highlights that according to its February 2021 analysis of MF portfolios, none of the mutual fund houses cross the threshold of 10% of such instruments at the asset management company (AMC) level. “However, 36 schemes spread across 13 fund houses breach the cap of 10% per scheme in securities,” the research outfit highlighted in a note.
The CRISIL analysis also finds that the banking and public sector undertaking (PSU) fund category has the highest number of schemes —seven—exceeding the 10% cap in such securities. Bank and PSU funds are followed by credit risk funds (five), medium duration funds (four), medium to long duration funds (four), and dynamic bond funds (three) categories.
Calling SEBI’s move to ‘grandfather’ limits previously held as a positive one, Piyush Gupta, director at CRISIL Funds Research, argues that in the medium to long term, with the restrictions in place, it could reduce appetite among MFs for these securities, thus limiting the risk for investors. “This is also prudent given the advent of hordes of individual investors into debt funds,” says Gupta. “They may not have the ability to understand MF portfolios and gauge risk, especially in such types of bonds—we saw how they were caught unawares by the recent write-offs,” Gupta says.
AT1 and AT2 bonds apart, the SEBI circular also notified MFs that the maturity of all perpetual bonds shall be treated as 100 years from the date of issuance of the bond, for the purpose of valuation. Under the currently prevailing norms, the call option date of the bond was considered for valuation calculations.
According to CRISIL Fund Research, this shift could cause volatility in bond pricing, especially of securities trading at a discount. It could also impact the portfolio maturity and duration, considering the change of maturity date of securities to 100 years, and cause volatility in the categorisation of schemes within the specific maturity dates.
Mumbai–based Uttara M. Kolhatkar, partner at law firm J. Sagar Associates, points out that the unexpected regulatory directive on perpetual bonds raises concerns on valuation as the perpetual bonds that have been issued would be revalued on account of the ‘100 years rule’ that the SEBI circular would have brought in its wake. Kolhatkar argues that the change would subject the instrument to generate losses on account of any marginal increase in interest.
“Perpetual bonds have no maturity date, therefore, payments theoretically continue forever,” says Kolhatkar. “The original flavour of such a capital instrument will be lost if it is fettered by a ‘tenor of 100 years’,” Kolhatkar adds.
Kolhatkar is also of the view that the SEBI directive would have a cascading effect on the bond market and could increase volatility. “Potential redemptions on account of this new rule would lead to mutual fund houses engaging in panic selling of the bonds in the secondary market leading to widening of yields,” he says. Gauging this possibility, the Department of Financial Services under the Ministry of Finance has reportedly written to SEBI to withdraw the guidelines related to the change in valuation norms.
However, largely from the investor’s perspective, the latest move to limit exposure to the specified types of securities would reduce the portfolio risk. “Investors should continue to monitor their portfolios on a regular basis and invest as per their risk-return profiles to meet financial goals,” the CRISIL Fund Research note advises.
As MFs adhere to SEBI's new risk management norms, those who invest in MFs should also relook at their ways of evaluating the choices. Hopefully, the lessons learnt in the recent past would remain fresh.