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SEBI caps funds' exposure to perpetual bonds

While cap on exposure to riskier bonds is in the right spirit, SEBI has also proposed changes to the valuation norms which may have unexpected side-effects.

SEBI caps funds' exposure to perpetual bonds

SEBI, in its latest circular, has capped mutual fund investments in debt instruments with special features like that of being able to convert into equity upon trigger of a pre-specified event (for loss absorption). Additional Tier I and Tier 2 bonds fall under the above-mentioned category. Effective from 1st April, no scheme can invest more than 10 per cent of its debt assets in such bonds and not more than 5 per cent in the bonds of a single issuer. Further, the watchdog said that no AMC, under all its schemes, will invest more than 10 per cent of its debt assets in such bonds issued by a single issuer. As an important implication, the set limits will ensure that funds don't go overboard with exposures to riskier bonds in pursuit of yields.

SEBI has grandfathered the current investments by AMCs in such instruments in excess of the specified limits. But such funds cannot make any fresh investment until their investment comes below the specified limits. Further, the funds with investments in such bonds will have to ensure enablement of the side-pocketing provision in their scheme information document (SID). Now, enabling the side-pocketing provision will work towards safeguarding the interest of existing investors in case of any unfortunate event.

Another regulation is regarding the valuation of such bonds, the maturity of all perpetual bonds for the purpose of valuation will be taken as 100 years from the date of issuance of the bond. Since close-ended debt funds can only invest in securities with maturity on or before the date of the maturity of the fund, the regulator banned these funds from investing in perpetual bonds.

Now many funds typically used the next call-option date for valuation purpose but since these bonds will now have to be valued as a 100-year maturity bond, duration funds which have to maintain a Macaulay duration within specified limit either may not be able to invest in such bonds or may have to substantially curtail exposure to such bonds. For instance, short-duration funds, which, by regulation, have to maintain a Macaulay duration between one and three years, will face difficulty in taking exposures to such bonds.

Having said that, this change in valuation norms have sparked some concerns in the fund industry as it may lead to significant drop in values of these bonds on a mark-to-market basis leading to drop in NAVs of funds which have exposure to these bonds. Further, reportedly Finance Ministry has written to SEBI to withdraw the 100-year maturity rule as the valuation norm can be fairly disruptive and may even lead to large scale redemptions from funds which hold these bonds. So, more clarity is still awaited on this valuation guideline.

Such bonds are typically issued by the banks and do not carry any maturity date. Given the higher risk, they typically offer higher yields than other debt instruments. Although these bonds are risky in nature, there was no specific limit for investment in these. The regulatory limits would be quite useful given the experience investors had with AT1 bonds during the Yes Bank fallout in early 2020. At that time, mutual funds had an exposure of about Rs 2,700 crore to the bonds/NCDs of Yes Bank spread across around 30 funds (as on Feb 29, 2020). These bonds had become toxic since they had to be written off completely, causing huge losses to those holding these bonds, including some mutual funds.