3 min read.Updated: 13 Mar 2021, 08:11 AM ISTProsenjit Datta
The markets regulator’s move is in the right direction but came at a time when neither the government nor the fund houses have the appetite for churn in the bond market
A Securities and Exchange Board of India (SEBI) circular regarding valuation of Additional Securities Tier 1 (AT-1) bonds on March 11 had sent shock waves through debt fund managers of mutual fund houses. A Finance Ministry note to SEBI today advising it to drop the 100-year maturity clause is soothing their frayed tempers. But while the Finance Ministry intervention may calm the anxiety of debt fund managers, the SEBI circular would probably have brought more transparency and realistic valuation of these bonds despite the short term panic it might have caused.
AT-1 bonds are perpetual unsecured bonds that banks issue as part of their capital base. They first burst into the consciousness of the average debt fund investor during the Yes Bank fiasco. The decision by Yes Bank to write down the AT-1 bonds made the average investor realise that these instruments may have been called bonds but were more of a quasi-equity instrument with a far higher risk profile. That was a year ago.
But the market confidence for these instruments slowly came back because most of the big banks with rock solid reputations had issued AT-1 bonds. And given the exposure norms for debt funds to these instruments, the risk was limited. Most debt fund managers were anyway careful about their portfolio’s exposure to such bonds.
The SEBI circular of March 11 was also not particularly contentious except for one clause. While much of the circular focused on the exposure limits of funds to such bonds, the clause that triggered panic was on the valuation norms that debt fund managers had to follow from April 1 for these bonds.
While these funds were perpetual in nature, debt fund managers tended to value them based on their call dates—the date at which the issuer could make an offer to call back the bonds and pay off the investors. It was not incumbent on the bank issuing it to do so, but it was valued as if it were. In practice, these bonds pay only interest or coupon in perpetuity while the capital amount remains with the issuer.
The SEBI circular said that since these bonds were perpetual in nature, they should be valued as if their tenures were for 100 years and not based on the call date. Valuing at call date assumes that both the capital and interest was being paid back by that date, which was not what happened in practice.
Debt fund managers were in a panic after the circular because they realised that they needed to revalue the AT-1 bonds values in their portfolio to comply with the new norms and these would inevitably be valued downwards. While this would essentially be in the nature of a paper adjustment and would not affect the actual returns of the fund in the long run, in the short run it could create a panic, especially among big investors who park a fair amount of money in debt funds. They could start redeeming their funds before April 1, causing a liquidity crisis of the kind that forced Templeton to wind up six debt funds last year. While the bigger fund houses would ride it out, the smaller ones would have to resort to panic selling of good debt to meet redemption pressures.
For the government there was a bigger worry. A second round of bad publicity about AT-1 bonds could completely kill off investor appetite for such instruments just when many public sector banks were looking to raise additional capital. They would be forced instead to rely on core equity dilution for raising additional capital, thus dampening the value of their shares. This in turn was not a prospect the government was looking forward to in a year when it hoped to raise some money by selling some shares in the banks that it owned. The government’s letter was probably triggered more by this than any other consideration.
From a long term perspective though, the SEBI’s logic on valuing the AT-1 bonds as 100 year bonds would probably have resulted in a more accurate representation of their values in fund portfolios. SEBI can, in consultation with the government, perhaps bring these norms back later—in a year when the economy is on a sounder footing.
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