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The finance ministry has asked the markets regulator to withdraw a rule that sought to treat banks’ additional tier 1 (AT1) bonds as having 100-year maturity, making investments in them one of the riskiest, as the government feared a sell-off in these securities would make it tougher for banks to raise capital.

The department of financial services letter dated 11 March to the chairman of the Securities and Exchange Board of India (Sebi) was in response to a circular issued by Sebi a day earlier, which among other rules, also limited investments by mutual funds in AT1 bonds. Mint has reviewed a copy of the letter.

The new Sebi rules that were to take effect from 1 April were aimed at reducing retail investors’ exposure to risky assets. In October, Sebi had barred retail investors from purchasing AT1 bonds. Sebi’s decision followed the Reserve Bank of India writing off 8,415 crore of AT1 bonds sold by Yes Bank Ltd as part of a rescue plan.

Emails sent to spokespeople for the finance ministry and Sebi didn’t elicit a comment immediately.

Sebi’s 10 March circular, however, generated apprehension in the mutual fund industry that the changes would result in a revaluation of such bonds, leading to a spike in yields.

While AT1 bonds have no fixed maturity, banks have the option, but no obligation, to buy them back at specified dates. Mutual funds have treated these dates, typically not more than 10 years, as maturity dates. Treating them as 100-year bonds would make them way riskier as longer-term bonds carry greater interest rate risk.

Mutual funds had expressed fears of a surge in redemptions by investors, anticipating losses. The relatively low liquidity of such bonds also makes them hard to sell.

“Regardless of whether the valuation provision of the circular is withdrawn, I would not recommend any funds with more than 5% of assets under management in AT1 bonds. These bonds have very low liquidity and are more akin to equity than debt. I don’t see why they should be in debt funds," said Feroze Azeez, deputy chief executive of Anand Rathi Financial Services Ltd.

The finance ministry letter expressed concerns about the impact on the net asset value of funds because of the new norms and possible disruption of debt markets as mutual funds sell such bonds in anticipation of redemptions. This can also affect capital-raising by public sector banks, forcing them to rely more on the government for capital, it noted. However, the ministry did not object to other provisions in the Sebi circular, such as those limiting AT1 bond exposure to 10% of scheme assets. “Considering the capital needs of banks going forward and the need to source the same from capital markets, it is requested that the revised valuation norms to treat all perpetual bonds as 100-year tenor be withdrawn. The clause on valuation is disruptive in nature," the letter said.

However, Amfi backed the regulatory cap on mutual funds exposure to perpetual bonds on Friday. “Only in the event of lack of traded prices, the question arises as to whether the bond should be valued to call or to maturity. Given a reasonably active market with regular trades, the issue is narrower than it appears," Amfi said.

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