New Delhi: A 10 March circular issued by Securities Exchange Board of India (SEBI), India’s capital markets regulator, on the treatment of the relatively risky bond issuances by banks, has placed it at loggerheads with the central government, with the finance ministry asking it to withdraw some of its directives.
ThePrint explains what these bonds are, the differing viewpoints and how this impacts retail investors.
What the SEBI circular says
The SEBI circular seeks to regulate investments by mutual funds in additional tier 1 (AT1) and additional tier 2 (AT2) bonds issued by banks under the Basel 3 framework. This is aimed at reducing the risks faced by mutual funds and the retail investors in them if any of the banks fail to meet their debt repayment obligation.
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The regulator has asked mutual funds to cap their investments in such bonds. According to the limits placed, one mutual fund cannot invest more than 10 per cent of its funds on such instruments issued by a single issuer. In addition, one mutual fund scheme cannot hold more than 10 per cent of its net asset value in such risky instruments. The exposure of one mutual fund scheme to issuances by one financial institution is capped at 5 per cent.
In addition, the capital markets regulator has stipulated that these bonds will be considered to be of a tenor of 100 years for the purposes of valuation. It has pointed out that close ended schemes or schemes with a definite maturity date cannot invest in these instruments.
AT1 bonds and why they are considered risky
Issued by banks, AT1 bonds are perpetual bonds, i.e., they do not have a maturity date. These are quasi equity instruments that regularly pay yields to the investors. Often these bonds are mis-sold to retail investors with bank representatives promising high returns without explaining the risks to the investors.
There are many risks attached to this high yield instrument.
Since there is no maturity date, it is entirely up to the bank whether to redeem these bonds or not after a few years. Banks, if they choose to do so, can continue to pay interest on these bonds without redeeming them. Typically, call options are built into the contract to allow banks to redeem these bonds if they wish to do so.
In addition, the fine print of these AT1 issuances allow the banks to skip paying interest to investors or even write down the value of these bonds in case its capital adequacy falls below some prescribed levels. The Reserve Bank of India (RBI) can also ask banks to completely write down these issuances, which means that entire investments in these bonds can be wiped off if the bank is not doing well.
The risks associated with AT1 bonds came to the fore when investors of Yes Bank’s AT1 bonds saw their entire investment in these bonds being wiped off. This followed the RBI’s decision to write down the entire value of AT1 bonds as part of the rescue package designed for Yes Bank.
Why finance ministry wants SEBI to withdraw provision
The finance ministry, while agreeing to the caps placed on investments made by mutual funds, has asked the regulator to withdraw the provision regarding the 100-year tenor proposed for valuation of these perpetual bonds “considering the capital needs of banks going forward and the need to source the same from the capital markets.”
In an office memorandum dated 11 March, it argued that this provision will reduce the appetite of mutual funds in investing in AT1 bonds issued by banks.
It pointed out that the move will lead to mark-to-market losses, reduce the net asset value (NAV) of mutual fund schemes and lead to panic in bond markets as mutual funds sell these bonds in anticipation of redemptions by investors.
Mark to market losses occur when the value of the bond holdings fall. Mutual funds are expected to continuously appraise their portfolio and provide the actual market value of their investments.
The memorandum also added that mutual funds may sell other bonds to raise liquidity and this could lead to higher borrowing costs for corporates at a time when “the economic recovery is still nascent.”
It further said that capital raising by state-owned banks will be impacted and this will force the government to infuse a higher amount of capital as core equity.
What this means for retail investors
After the Yes Bank crisis, SEBI had issued norms to ensure that retail investors could not directly buy the bonds. These included a minimum lot size of Rs 1 crore and allowing only institutional buyers to purchase these instruments.
However, this still left those retail investors, who were investing in debt mutual funds, vulnerable. This is because even though these debt funds were marketed as safe investment options (compared to the risk associated with equity investments), some mutual funds were investing in high risk AT1 issuances.
SEBI’s circular is aimed at ending the practice of short term funds investing in these long term instruments for the allure of higher return.
If SEBI does adhere to the finance ministry’s request, retail investors will again face risks in their relatively safe debt portfolio.
(Edited by Manasa Mohan)