SEBI Reforms For AT-1 Bond Pricing Leaves Mutual Funds Puzzled

A move which nearly killed the additional tier-I bond market over three years ago has come back into the limelight. Securities Exchange Board of India’s move to ease valuation norms of Tier-I bonds by mutual funds has left market participants confused about whether the appetite for the bonds will come back.

Last week, the capital markets regulator said that the valuation of tier-I bonds by mutual funds will be on a yield to call basis. This is a departure from the norms that it had introduced in March 2021, where it directed mutual funds to value these bonds as 100-year instruments.

“…in order to align the valuation methodology with the recommendation of NFRA (National Financing Reporting Authority), it has been decided that the valuation of AT-1 bonds by mutual funds shall be based on yield to call,” SEBI said in its circular.

While the regulator has changed the stance on the valuation of Tier-I bonds, the duration of the bond will continue to be 100 years.

This change is a partial relief for investors but a not significant one because mutual funds will continue to find it difficult to add Tier-I bonds in their schemes due to their perpetual nature, four fund managers told NDTV Profit.

Basel-III compliant Tier-I bonds are essentially perpetual bonds that have trigger points linked to a bank’s capital and earnings. If these triggers are breached, it can lead to interest payments being stopped. This situation could even lead to conversion of the bond into equity.

Call options are where the issuer can call the bond back after paying principal and interest, in the middle of the tenure.

While some money managers believe that the renewed norms will not bring any material change to mutual funds' appetite, others believe that demand may slightly increase as they can be added to balance funds, medium-term funds and medium to long-term funds.

SEBI’s decision, followed by the National Financing Reporting Authority’s recommendation has come as the secondary market of corporate bonds continued to trade these instruments on a yield to call basis. They consider the call option of typically five years or 10 years from the date of the issuance.

Calls and messages to a spokesperson for SEBI were left unanswered at the time of filing this story.

What prompted SEBI to tighten valuation norms for mutual funds in the first place was the Yes Bank fiasco and some concerns around mis-selling of these papers. In early 2020, Yes Bank had to write off perpetual bonds worth Rs 8,415 crore as it was strapped for capital.

As demand from mutual funds took a hit, issuances of tier-I bonds by banks also declined in the primary market. According to PRIME Database, banks issued tier-I bonds worth Rs 16,363 crore in 2023-24 (April-March), lowest in the past four financial years as compared with Rs 34,394 crore in 2022-23.

This also drove the pricing on such papers, making it difficult for banks to garner enough demand.

With the latest change in regulation, supply of these papers and liquidity may increase. Merchant bankers believe that State Bank of India and other public sector banks may start lining up their tier-I bond issuances.

However, concerns over mis-selling of such instruments remain.

“Going forward, we will see demand for such instruments. However, the biggest issue with such bonds is mis-selling. There has to be severe penalties for mis-selling of such instruments. That loophole has not been closed yet,” Deepak Sood, Head Fixed Income at Alpha Alternatives said.

Another issue that mutual funds might face would be taxation as the government has directed that profits from debt mutual funds will be classified as short-term capital gains, irrespective of their holding periods.

"Although an increase in demand for AT1 Bonds is expected, it is tempered by the current tax environment," Venkatakrishnan Srinivasan, founder of Rockfort Fincap said.

"Since April 1 of last year, capital gains from debt mutual funds are taxed according to the investor's income bracket, which has slowed inflows into debt funds. As a result, the potential increase in demand for AT-1 Bonds from debt MFs might be more moderate than it otherwise would have been," Srinivasan said.

Further, SEBI's rule that no mutual fund should own more than 10% of a single issuer's Tier-I and Tier-II capital also remains. This cap on investments will keep demand for these bonds limited.