The Association of Mutual Funds in India (AMFI) has come up with the guidelines that mutual funds will need to follow from April 1, 2021, to value additional tier-1 (AT-1) and tier-2 bonds of banks.
The Securities and Exchange Board of India (SEBI) had advised AMFI to issue its set of guidelines for mutual funds (MFs), after allowing MFs to value AT-1 or perpetual bonds as ten-year papers for now, and move to 100-year rule gradually over the next two years, i.e. from April 1, 2023.
Debt market experts say these guidelines will help MFs know how they should value such bonds when there are no fresh trades in the markets and no price discovery.
“Debt papers don’t trade frequently like equity and with new SEBI rules coming into effect in next few days, this guidance should give more clarity,” says Joydeep Sen, corporate trainer-debt markets.
What do AMFI guidelines say?
Each bond security issued by a company is identified by an ISIN code. AMFI guidelines say that even if one ISIN of the bond issuer trades, all other ISINs will be considered as traded. The valuation of these ISINs though will differ from the traded security, as it has to account for the YTM spreads.
As per SEBI’s new rules, AT-1 or perpetual bonds need to be now valued at Yield to Maturity (YTM), from earlier practice of Yield to Call date, when the company is expected to buy back the bond and return money.
In case, none of the securities of the bank are traded, MFs can refer to traded price of securities issued by a similar bank with similar maturities. As mentioned above the final valuations will still need to be adjusted for the YTM spread.
However, in any case, if ISIN of an AT-1 bond is traded, it will not be treated that Tier-2 bonds of the same issuer have also traded.
Using past traded prices
The AMFI guidelines say that if there have been no trades even in similar securities, past trades can be referred to.
For benchmark ISINs, past trades up to last 15 days can be referred to, for non-benchmark ISINs, trades up to 30 days can be referred. Starting from October, the number of days will be shortened to seven days for benchmark securities, and 15 days for non-benchmark ones.
These two groups of ISINs will be decided after consultation with valuation agencies.
At present, SBI securities are used as a benchmark across all maturities for AT-1 or perpetual bonds.
Even though past trades can be referred, the final valuation has to reflect any adverse news, change in credit rating, interest-rate movements, etc, which will impact the yields of the ISIN being valued.
Reverting to 100-year rule
As per SEBI’s new rules, the AMFI guidelines also state that if the bond issuer of an AT-1 bond does not exercise its call option on the call date, all the securities issued by that issuer will have to be valued as 100-year papers.
Disclose yield to call and yield to maturity
Your mutual fund schemes will also start disclosing yield to call and yield to maturity of the bond security from April 1, 2021.
This will give you an understanding of how the bond is getting priced in markets, by other bondholders. Other debt market investors like insurers and high-net worth investors still use the Yield to Call method to value AT-1 or perpetual bonds.