The circular issued by the markets regulator on Wednesday had the potential to create problems on Reserve Bank of India’s turf as it could have triggered a selloff by MFs of these bonds issued by public sector and private banks.
A selloff risk was created because if MFs held on to the bonds, the Sebi directive would have led to a dip in net asset value (NAV) of debt funds from April 1 when the circular became effective.
In an office memorandum, the department of financial services said that MFs currently hold more than Rs 35,000 crore of the total bank AT1 issuances of about Rs 90,000 crore. The memo said that the Sebi circular would limit the ability of MFs to buy bank bonds and the coupon rates on them would rise.
“The abrupt drop in valuation is likely to lead to large NAV swings and potential disruption in debt markets. This measure will also take away the appetite for MFs for investing in such instruments, given valuation norms,” the memo said. The ministry also feared panic redemption of MFs impacting the overall corporate bond markets.
The genesis of the problem with AT1 bonds lay in the RBI’s reorganisation plan for the failed Yes Bank, which resulted in AT1 bonds issued by the lender being extinguished even as shares continued to trade. This story was repeated in the case of Lakshmi Vilas Bank.
The decision to extinguish the bonds was taken keeping in view that the terms of the issue included some loss-absorption feature in those bonds where investors would not be paid if the bank were to fail. Given that investor protection was part of Sebi’s turf, market players said that the move to curb AT1 bonds was justified.
Funds body AMFI on Friday supported Sebi’s stance, stating that AT1 bonds are issued without any maturity date, but are usually issued with call option(s) and qualify for tier-1 capital.
“Most trades in AT1 bonds happen on a yield-to-call basis. This is based on the established market convention, locally as well as globally, that the issuer will exercise the call option on the due date,” it said.
Despite the hybrid nature of these bonds, rating analysts said they will continue to analyse them as debt instruments, “based on willingness and ability to repay” by the issuers.
“The government ownership and support will be weighed in while rating bonds issued by public sector banks. But recent events could reduce the investors’ appetite for these bonds,” said ICRA VP & sector head (financial sector ratings) Anil Gupta. “Top-rated private banks will not have a problem when their existing bonds mature as they have raised adequate capital.”
Sebi had engaged with AMFI on the treatment of AT1 bonds as it is a hybrid instrument and carries a differentiated risk-reward ratio than a normal debt instrument. “Treatment of AT1 bonds was discussed in the Mutual Fund Advisory Committee where several members of AMFI participated,” it said.
The trade body fully supported “the need and spirit” of Sebi circular in capping exposure to AT1 bonds. It also supported Sebi’s objective of fair valuation. However, AMFI was in discussion with Sebi to further smoothen the process of implementation of this circular.