- Wealth PMS (50L+)
SEBI has now regulated debt mutual funds in ways that will change how debt funds operate. A quick synopsis:
We’ve suggested many of these at Capitalmind earlier, and are really happy that SEBI has done this.
Details and impact, follow.
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:
The impact is pretty big for AT1 bonds overall. We’ll come to that.
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.
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).
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%.
They will not be able to buy more AT1 bonds.
Our view is:
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.