New SEBI Rule about Perpetual Bonds: How it affects Debt MF Investors?

SEBI has modified investment norms for debt mutual funds for investing in bonds that are quasi-equity in nature. Such bonds can be made to absorb losses before equity or may be convertible to equity in case of a specified event. Additional Tier 1 and Tier 2 bonds (AT1 and AT2) are such bonds. The rules come into force on April 1, 2021.

What are AT1 and AT2 bonds?

These bonds are used by banks to shore up their capital and meet capital requirements as per BASEL III norms.

These are perpetual bonds i.e., these bonds have no maturity. Thus, the banks do not even have to pay back the principal if they wish. They can just keep paying the periodic interest. And the claims of such bondholders can be subordinate to equity investors. In the case of Yes Bank, RBI wrote down the AT1 Bonds to zero (equity was not written down to zero), resulting in a total loss to AT1 bondholders.

In case of Laxmi Vilas Bank, both equity and AT2 bonds were written down to zero.

Hence, unlike other bonds, these AT1 and AT2 bonds are much riskier bonds.

Therefore, SEBI, in its circular dated October 6, 2020, specified that AT1 bonds can be issued only to Qualified Institutional buyers (and not retail investors).

What has SEBI announced?

1. No AMC (under all its schemes) shall own more than 10% of such instruments issued by a single issuer.
2. An MF scheme shall not invest more than 10% of its debt portfolio in such instruments.
3. An MF scheme shall not more than 5% of its portfolio in such instruments issued by a single issuer.
4. Close end funds cannot invest in such bonds.
5. If a bond has call/put option, the price of the bond shall be considered lower of price to maturity and price to call/put exercise date.
6. The maturity of all perpetual bonds shall be considered as 100 years for the purpose of valuation. (This can be a problem. We shall see later.). Note that there can be perpetual bonds that are not AT1 or AT2 bonds.

What if a debt mutual fund scheme is already breaching these limits?

Such exposure shall be grandfathered. Therefore, the debt MF schemes do not have to worry about cutting their existing exposure.

However, such schemes cannot make any further investments in such bonds until their investment comes below the specified limits.

What prompted SEBI to do this?

The MF guys were gaming the system.

We have seen quite prominently in the case of Franklin Ultra Short Bond Fund scheme.

The Franklin scheme is an ultra-short duration fund, where the average maturity (duration) must be between 3 and 6 months. You would expect that the fund would hold bonds that were maturing between 3 to 6 months. However, the fund held a few bonds of much longer duration, going up to as high as 10 years. Makes little sense.

Why the MFs do this?  To earn better returns. Longer maturity bonds pay higher interest shorter maturity bonds. Helps the debt funds prop up the performance.

But how could they do this?       

This brilliant CapitalMind article points out the issues. The MFs can invest in floating-rate bonds or callable/puttable bonds.

Now, the trick.

The fund can invest in a 10-year floating rate bond. A floating rate bond would have interest-reset dates. To calculate residual maturity, the residual period to next reset date was considered. If the next interest reset is 6 months away, the scheme would consider bond maturity as 6 months and not 10 years.

OR

The fund invests in a perpetual bond (Callable bond). A perpetual bond has no maturity. For the average maturity calculation, the nearest CALL date shall be considered. By the way, this approach can be used even for say 10-year bonds, with next CALL date 6 months away.

If a bond has a call option, the bond issuer (borrower) has the right (not obligation) to return your investment on a specified date (before its maturity date).  So, the issuer can force the investor (lender) to take back the money on the CALL date. The bonds with an in-built call option are called callable bonds. The issuer may exercise such an option if it can refinance debt at a lower interest rate. For instance, if the callable bonds were issued at 9% interest rate and the interest rates have moved down since then and the issuers can now issue bonds at 7%, it will issue new bonds and CALL the older bonds. This helps reduce their cost of capital.

If the bond a put option, the investor (lender) has the right (not obligation) to demand their money back from the issuer on a specified date (before its maturity date). Such bonds are called Puttable bonds.

While the SEBI circular under discussion does nothing to address the issues with floating rate bonds AND even does not completely address the problem of call/put options, it does attempt to address the issue of using perpetual bonds inappropriately in MF schemes.

What are the good points?

SEBI has realized that many mutual fund schemes have not been true to label. There is no place for perpetual bonds in portfolio of an ultra-short duration or a low duration debt fund.

With this change, the perpetual bonds can’t be part of portfolios where there are restrictions on average maturity. So, the ultra-short duration, low duration bonds or short-term bond funds to have perpetual bonds in the portfolios.

Why?

If a low duration debt fund has only 1% money in perpetual bonds (whose maturity will be considered 100 years), this bond itself will take average maturity to 1 year. Thus, difficult to see perpetual bonds in such portfolios.

And the unintended consequence

Now, perpetual bonds have no maturity dates. Perpetual bonds usually have CALL dates. No PUT dates.

So, they are usually valued to CALL dates (as if that were the date of maturity). Now, SEBI says that the date of maturity of such perpetual bonds be considered 100 years from the date of issuance.

And this can affect valuation of such perpetual bonds in debt mutual fund portfolios.

How?

Let us consider an example.

A scheme has invested in a perpetual bond. The bond is callable in 1 year.

Now, the AMC will price it as if the bond is maturing in 1 year.

The perpetual bond pays a coupon of 7% p.a.

Assume the prevailing 1-year bond yield (of similar quality bonds) is 5.5%.

In that case, such bond will be priced at 101.4.

Accordingly, the MF portfolio will calculate its NAV.

Now, as per the new SEBI rule, the same bond must be valued as if it is maturing in 100 years.

I do not think we have a benchmark for a 100-year bond yet. However, we do know that long duration bonds usually trade at higher yields than short duration bonds.

Why?

When you lend for 3 months, you are almost sure that nothing will go wrong in these 3 months and you will get your money back.

The same can’t be said if you are lending for 30 years. Things can go wrong. And you must be compensated for higher risk. That’s why investors demand higher yields (or interest rate/coupon) for longer maturity bonds.

You might think that governments don’t default but these bonds are not just issued by the Government. And corporate bond defaults are not uncommon.

RBI recently auctioned 364-day (1-year) Treasury bills at 3.85% p. a.

Current, 10-year Government Bond yield is ~6.23% p.a. That is 2.3% p.a. higher than 1-year bond.

The difference is not always so stark, but this gives an idea.

The above was Government Bond and a 10-year bond.

We are talking about bond (issued by the bank) and that too a 100-year bond.

So, we need to add a significant risk premium.

Let’s say the yield-to-maturity (YTM) of such a bond is 8% p.a. So, we must value the bond as if the YTM were 8% p.a.

The price of the same bond falls to ~Rs 87.5. That’s an almost 15% cut from current price.

If the YTM used were 8.75%, the price falls to Rs 77. Almost 25% cut.

Note: This is just a hypothetical example. Different results can pop up for different combination of coupon, 1-year yields and 100-year yields. Or the bond may be callable after 5 years (and not 1-year) as I have assumed.

However, one thing is clear. There can be a significant price erosion on values of some of these bonds.

And the impact

If your debt MF scheme has 1% exposure to such a bond, the impact will be minimal.

Even the price of such a bond is cut by 25%, the impact on MF scheme NAV is only 0.25%. Negligible.

However, there are schemes that carry much higher exposure, as this article in Economic Times points out.

Expectedly, some of the banking & PSU debt funds have significant exposure to such bonds. So, if your scheme has 15% exposure to such bonds and the value of such bonds is written off by 25%, the NAV of the MF scheme will go down by 3.75%. That is a big hit to a debt mutual fund scheme.

Now, if you know that the NAV of your scheme will go down by 3.75% on April 1, 2021, you might consider exiting this investment. As more investors, the allocation to perpetual bonds will increasingly become a higher percentage of residual portfolio. More investors will therefore want to exit the fund. AMCs know that. Thus, they might try to sell off the perpetual bonds from their portfolios to contain the damage. But the portfolios won’t be out until the second week of April. So, investors are in the dark about the actions the AMCs are taking. Whole lot of confusion.

Points to Note

1. This is a hypothetical example. The impact may not be as much.
2. A lot depends on the allocation of your MF scheme to such bonds and whether these bonds are traded. If the allocation is low, the impact will be minimal.
3. As per SEBI valuation norms, these calculations (as shown above) about the price of a bond come into picture ONLY if the bond is not traded for over 30 days. If the bond is traded with a decent turnover (> Rs 5 crores), then the traded price of such bond will be used for calculation. No need to consider the maturity of 100 years.

The Government is worried

A day after the SEBI circular, the Ministry shot off a letter to SEBI requesting them to claw back the provision that requires maturity of perpetual bonds to be considered 100 years. The Government is fine with other provisions.

Why is the Government worried?

Mutual Funds are one of the largest investors in perpetual bonds and currently hold AT1 bonds worth more than Rs 35,000 of the total outstanding of Rs 90,000 crores.

AT1 bonds are considered capital as per Basel III norms.

With these restrictions, these demand from mutual funds for such investments may subside.

If there is not enough demand for these bonds from mutual funds, then the Government will be forced to provide equity from its pockets. And that’s a burden.

The letter also points to Mark-to-market losses for the debt mutual funds (as we discussed earlier). Or mutual funds might be forced to sell such investments in a hurry. This could result in panic in the corporate bond markets.

What should you do?

First, check the level of exposure of your scheme to such bonds. You will have to look at Monthly Portfolio disclosures to figure this out. If the exposure is small, you don’t have to worry.

Secondly, assess the impact of such Mark-to-market losses (this can be quite time-consuming and difficult to assess). Moreover, if such bonds are properly traded, such calculations won’t come into picture. Not sure how to get that info.

Thirdly, wait for the SEBI response to FinMin letter. It is possible SEBI might claw back the 100- year rule or extend the applicability. Extending applicability can be a healthy compromise.

Lastly, if the exposure to AT1 bonds in your scheme is high and there is no clawback (or extension) of 100-year rule, you might want to reconsider your investment in the MF scheme.

In general, after what happened with Yes Bank AT1 bondholders, you should avoid schemes with heavy exposure to AT1 bonds, especially from weaker banks.

Additional Links/Source/Credit

CapitalMind: Mutual Funds can’t own AT1 Bonds easily

SEBI Circular dated March 10, 2021: Review of norms regarding investment in debt instruments with special features

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