The Securities and Exchange Board of India (SEBI) recently imposed regulations on mutual funds (MF) investments across additional tier-1 (AT1) bonds. The circular kicked up a storm in the banking and MF sectors. The Ministry of Finance (MoF) requested SEBI to withdraw the restrictions since the changes could hamper banks’ fund-raising plans and disrupt mutual funds investments.

After the MoF intervened, the market regulator decided to ease the valuation rules on AT1 bonds ushering in relief for MF investors. If you are wondering what these new regulations are and how do they affect your mutual funds’ investments, here’s all you need to know.

What are AT1 Bonds?

Additional tier-1 bonds are unsecured bonds with no pre-determined maturity date. Here, tier 1 comprises a bank’s core capital, disclosed reserves, and equity. AT1 bonds, clubbed under perpetual bonds, offer a call option which means their issuers; usually, banks, can repurchase them from you. Besides, if banks face bankruptcy or run short on capital, they can dismiss the principal amount and not pay interest.

Financial institutions issue these bonds to fulfil their capital adequacy requirements. CAR is an assessment of a bank’s capital and its risk-weighted assets. Capital adequacy norms were formulated under the Basel III accord of 2009 after the credit crisis of 2008. It states that banks must maintain a capital adequacy ratio (CAR) of at least 8%. However, in India, Reserve Bank of India (RBI) norms mandate that India’s public sector banks maintain a CAR of 12% and scheduled commercial banks require maintaining a CAR of 9%.

In perpetual debt instruments, mutual funds are the largest investors holding more than Rs 35,000 crore, over one third, of the outstanding AT1 bond issuances worth Rs 90,000 crore. For investors, the eternal tenure of these bonds and the call option lead to an increased risk but also fetch greater yields than other debt securities.

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What Are SEBI’s New AT1 Bond Rules for MF?

In a directive, SEBI stated that MFs must value these perpetual-tenured debt instruments as 100-year bonds. It means mutual funds would operate on the assumption that banks will redeem AT1 bonds in 100 years. Besides, the statutory regulatory body limited the MFs’ ownership of AT1 bonds at 10% of a scheme’s assets. According to the circular, SEBI expected the changes to take effect from April 1, 2021.

However, after the Finance Ministry asked the regulator to review these regulations, SEBI amended the valuation norms. As per the latest circular, the residual maturity of Basel III AT1 will remain unchanged at 10 years until March 31, 2022. The regulator didn’t withdraw its regulations but deferred the implementation by two years.

Owing to the high-risk appetite of AT1 bonds, SEBI will increase the maturity tenure to 100 years from April 2023. The expiration date will be counted from the bond’s issuance date.

Impact on Mutual Funds

Currently, mutual funds treat the call provision date as the maturity date on AT1 bonds. If these perpetual-tenure bonds become 100-year bonds, it increases the risk since they will develop into ultra-long-term financial instruments. Besides, it could accelerate market volatility in the bond valuations.

As bond prices rise, bond yields fall. Thus heightened risk will lead to escalated bond yields, and a higher yield will, in turn, reduce the net asset value of mutual funds schemes holding the AT1 bonds. Due to SEBI’s relaxations, mutual funds will not experience panic redemptions and losses. Furthermore, since these debt instruments are not liquid, mutual funds investors cannot immediately sell their bonds to meet the redemption pressure. But the relaxing norms will ensure an orderly liquidation of additional tier-1 bond holdings.

Additional Read: Top things to know about Corporate Bond investments

Wrap Up

The move from SEBI can serve as a risk-mitigation solution to decrease portfolio risk in debt mutual funds portfolios. However, potential redemptions due to the regulations can lead to panic selling of mutual fund bonds and increase the bond yields.

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