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Mutual Funds

Mutual Funds Can’t Easily Hold AT1 Bonds, Says SEBI

SEBI-scaled.jpg

SEBI has now regulated debt mutual funds in ways that will change how debt funds operate. A quick synopsis:

  • Funds cannot easily buy AT1 (Additional Tier 1) bonds issued by banks
  • Funds must have “segregation” rules on any funds that buy AT 1 bonds
  • Perpetual bonds should be treated as 100 years in duration, even if there are put/call options

We’ve suggested many of these at Capitalmind earlier, and are really happy that SEBI has done this.

Read: How Debt Funds Bluff Regulations and What SEBI Can Do About It

Details and impact, follow.

Additional Tier 1 bonds by banks: restrictions

AT1 and AT2 bonds have been written off recently in two banks – Yes bank (read post) and Lakshmi Vilas Bank (Read post). If a mutual funds had held those bonds, they would have had to mark them down to zero. In certain other cases, debt instruments contain features that allow them to be converted to equity.

Funds will see restrictions from investing in such bonds, starting April 1:

  • Such bonds can only be 10% of a scheme (and less than 5% of a single issuer)
  • The mutual fund AMC cannot own more than 10% of such bonds issued by a bank (across all its schemes added up)
  • Close ended mutual funds will not invest in such bonds at all. (more on this later)
  • If they already own them, they can’t buy more than 10% etc. – but needn’t sell. Essentially, they are grandfathered.

The impact is pretty big for AT1 bonds overall. We’ll come to that.

Funds must segregate when there’s a problem

Funds can own these bonds. But funds will have to “segregate” (or side-pocket) these investments if there’s a problem. That’s exactly what segregation is for – you move the problem bonds into a “bad fund” which cannot be bought or sold. And when you recover the money, you pay the investors back. In AT1 bonds where there is a partial write-off, there’s some value left. If it’s a total write-off (like Yes or LVB) then investors get nothing from the segregated fund. The main fund moves on anyhow.

This has very little impact, other than forcing most debt funds to enable segregation.

Big Deal: Perpetuals are now 100 years in duration

We discovered in the post in April that many funds have perpetual bonds (including Additional Tier 1 or Tier 2 bonds) in short term debt funds. (Read post) In these cases, they consider an option (a put or a call) to be the effective maturity date, because perpetuals have no maturity by definition of the word “perpetual”.

Call options are where the issuer can call the bond back after paying principal and interest, in the middle of the tenure. Put options is where an investor can force the issuer to pay back the money. Usually AT1 bonds have a call option 10 years after issue. Funds use this call date to say this is the maturity date, since obviously an issuer will call it back. Nothing obvious about it, but the industry wets its pants if an issuer doesn’t call. So the issuer will call and pay, and immediately issuer another AT1 bond in order to have the money to pay. This is an effective “rollover” but they need to do it.

To avoid all these complications, SEBI has told mutual funds that Perpetuals are now considered 100 years to maturity (from issue date).

  • Close ended mutual funds, therefore, cannot own them. There’s no mention that this part is grandfathered, btw. So it could be that close ended funds that hold them, are forced to sell.
  • All other “term based” funds – like a low duration fund (average duration: 6 months to 1 year), or ultra short term funds (average duration: 3-6 months) cannot hold such bonds.
  • You can still own such bonds in other kinds of funds (like PSU and Banking funds, income funds etc) within the 10% limit.

Impact! Big Changes for a lot of debt funds

In a regime where bond yields have fallen substantially, the AT1 market was helping a few funds prop up their returns. Take this HDFC Banking and PSU Debt Fund – I’ve filtered out the list of Perpetuals below and they show a 16% allocation to perpetuals! And ICICI PSU and Banking debt is apparently at 20%.

PSU and Debt

They will not be able to buy more AT1 bonds.

Our view is:

  • Demand for AT1 bonds comes largely from mutual funds. According to Crisil, the AT1 bond market has about Rs. 90,000 cr. outstanding (2019). This would have shrunk a little, but even assuming that, mutual funds altogether own about 38,000 cr. of it.
  • That’s means the AT1 market is largely dominated by the MF industry – who own it on their books.
  • The AT1 market will not see that much enthusiasm from mutual funds, going forward. Limits on percentage owned, plus rules against holding them in term products means there will be lower demand.
  • That should hurt the price in the market for AT1 bonds, at least to some extent.
  • There is also another problem in valuation. With a defined maturity of 100 years, SEBI valuation norms require that the price be the lower of a) the price to maturity and b) the price of the bond to the call option date. Perpetuals were priced to call option dates always, because there was no maturity. But it could easily be that the price is lower at a 100 year maturity, which revalues all such bonds in mutual fund portfolios immediately.
  • Nothing may change immediately but over time, mutual funds will show lower returns (since juicy AT1s no longer available) and the AT1 bond market will also struggle to issue or rollover.

Overall, this is a good regulation. It may hurt funds that have a very high concentration in AT1 bonds, and other perpetuals, but this will stop them from being bought in products where they don’t belong – like duration oriented schemes, or in closed ended schemes. Limits in other funds too are useful.

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