Mutual Fund

AT1 & Tier II Bond Risks hiding in plain sight!

“The best approach here, if at all possible, is to use supervisory and regulatory methods to restrain undue risk-taking and to make sure the system is resilient in case an asset-price bubble bursts in the future.” Ben Bernanke

I am a strong believer that the Indian financial regulatory environment is managed quite well. The way Indian banks are regulated and monitored, it has resulted in the history such that no consumer of a bank has faced the loss of capital over last 2 decades. Even though the bank failures/ mergers have happened, still it has been a largely salvageable situation. In recent times, banks like Yes bank or Lakshmi Vilas bank has gone through the restructuring and it has exposed one of the risk associated with the Additional Tier 1 (AT1) bonds. Recognizing the same risk, SEBI has come out with a proactive regulation to limit this risk exposure for Mutual Fund investors. This in my view, is a very welcome move as a regulator to protect the retail investors capital.

SEBI in it’s circular dated Mar 10, 2021 has addressed this issue. Currently, There is no limit on exposure to such bonds by AMCs in their funds. SEBI has prescribed that Any AMC should not own more than 10% of such instruments issued by a single issuer. Also, Individual Mutual Fund scheme shall not invest more than 10% of its NAV of the debt portfolio of the scheme in such instruments and shall not have more than 5% of its NAV of the debt portfolio of the scheme in such instruments issued by a single issuer. These are significant limits as in current situation there are 22 funds that have over 10% exposure to AT1 and perpetual bonds as on February 2021. (Source: Morningstar India) As per the regulation, the current exposure would be grandfathered and AMCs can make fresh investments in the perpetual bonds only once their exposure comes within the prescribed limits.

Though the clause of grandfathering would not be much useful for debt funds which have restriction on their Macaulay duration like Low/ short or Medium duration bond funds as per Oct 2017 circular by SEBI. As the AMCs have to value the perpetual funds with maturity of 100 years, the Macaulay duration is set to be changed drastically. Even though the clarification given on Mar 22, 2021 has updated the maturity applied to increase in phased manner, still the impact might be significant.

For e.g. the Low duration funds should have Macaulay duration of less than 1 yr. HDFC Low duration fund has exposure of 11.74% to perpetual bonds. One such bond is STATE BK OF INDIA 8.75% S-II perpetual bond. The bond has the issuer call option for Sep 2021, which means if issuer calls to redeem this bond it will mature is 5 months from today so it’s maturity is <1yr. Though if we have to calculate the Macaulay duration of this bond as per new regulation the maturity as 10years & expected YTM of 8.7% for AA+ category bonds, it comes out to be 7.06years. Therefore, 12% exposure in 7Yrs Macaulay duration would make the portfolio Macaulay duration of 12% * 7 = 0.84 and this means the fund should have the remaining 88% of the portfolio with maturity of <0.2years. This is quite difficult to achieve and the fund have to make lot of changes to adhere to the new regulation of valuation of perpetual bonds along with maintaining the Macaulay duration of <1yr.

As I have mentioned earlier (Investing in TINY world) that at present it does not make sense for having duration exposure in your portfolio. The current regulatory change would increase your exposure to interest rate risk. You should review your funds in your holding and probably opt for one of the actions as per me. Exit should be done in optimal manner to have lower tax/ exit load impact.

  • If the portfolio holds <5% of assets in form of perpetual bonds, you should not worry and consider the fluctuations in it’s NAV as part of market risk you have signed for
  • If the exposure is 5-15%, and your debt fund is of Low/ Short/ Ultra Short duration or 15%-20% in your Banking PSU/ Medium duration fund then there is problem as the fund has to value funds with assumed maturity of 10 years in short run. This will increase the interest rate risk as well as Macaulay duration of the fund so the fund houses might have to reduce the exposure. This would have an impact on NAV and if you have a really large exposure, you should contemplate reducing your holdings (Speak to your advisor/ distributor)
  • If your fund has >20% exposure & your have significant investment in such fund than consider to get out of such fund

It is important as an investor to understand such products in details. Attached link shares the details of such perpetual bonds, which clearly states its risk (refer the term sheet from page 78). These bonds are Non-convertible, Perpetual, Taxable, Subordinated, Unsecured. each term in it’s definition poses a risk. If you thought that the interest rate on bonds is higher and probably covers for the risk, I would recommend to read page 86 for Coupon Discretion & Page 88 for Loss Absorbency. The coupon is discretionary as well and if issuer needs to cancel the coupon, it can with no recourse available to bond holders. Hope this helps you understand the positive intent of SEBI to limit exposure to such bonds.

Lastly, Don’t just think that the regulation is going to impact just the debt funds. It will also impact your Hybrid aggressive funds as well. Even though there is no Macaulay duration limit applicable to such funds, They would have to comply with the 10% upper limit of exposure in the debt portfolio. In simple terms, I would interpret this as follows: “If the Hybrid Aggressive fund has 25% exposure to debt than no more than 2.5% of the portfolio should be in perpetual bonds.” If my interpretation is correct, this might be a bigger trigger of upheavals in aggressive fund category as all of the Top 3 funds (SBI Eq Hybrid/ HDFC Hybrid Eq & ICICI Pru Eq & Debt) by AUM have >3% exposure to perpetual bond funds. ICICI Prudential Eq & Hybrid has the higher exposure among the three funds 9.53% of the fund AUM as of Feb 2021. Similar would be the story in Balanced advantage funds or conservative hybrid funds.

In Summary, Please do no invest and forget your investments. Keep monitoring for the impact of such regulatory changes and make the necessary amends in your portfolio. If you find it difficult to monitor your portfolio at your end, speak to your advisor or distributor to understand such impacts or stick to simple products for investments which avoid such risks. It is your money and your responsibility to monitor the same. Happy Investing!

Write to us or leave a comment, if you want to enquire about any specific fund in your own portfolio. Feel free to share it with your friends & family, if it helps them or educate.

Investment Objectives & Advice

Madness in March!

“One of the best rules anybody can learn about investing is to do nothing” – Guy Spier

Most people underestimate the importance of doing nothing, when it comes to investing. Last Year, when the news of pandemic hit the markets and worldwide the market started to decline on a fast track, lot of people end up exiting their investments. In the last financial year, from Apr 1, 2020 to today Mar 31, 2021 Nifty 50 TRI has gained 80% and Nifty Midcap 100 TRI has gained 107%. Investors, who had jumped the ship, have missed the rising tide completely. Few of the brave hearts have jumped in March 2020 so they wanted to book the profits and get out of market, I had shared some ways to do so in my June 2020 article. This year March was quite easy compare to last year, we have seen the market top at 15,300+ as well as a quick 5 days sell off in the mid-month. If you want to get out of the market to book your profits, I would strongly recommend to read the June article. There are so many things to discuss from the march headlines, so let’s tackle them one by one.

SEBI’s new regulation on how to value the Perpetual bonds and limit on exposure to AT1 bonds: First of all, let me share my view about this regulation that “It is an important step towards strengthening the debt market & debt mutual funds transparency.” I do not have to remind of the recent write down of AT1 bonds of Yes Bank as well as Lakshmi Vilas bank. Second is that If in short run your invested funds show loses, do not cry foul on regulators or AMCs or your advisers/ distributors. Third, Let’s analyse the next steps of actions to be taken. You should look through the latest portfolio disclosure of the debt fund or Hybrid funds you hold.

  • If the portfolio holds <5% of assets in form of perpetual bonds, you should not worry and consider the fluctuations in it’s NAV as part of market risk you have signed for.
  • If the exposure is 5-15%, and your debt fund is of Low/ Short/ Ultra Short duration or 15%-20% in your Banking PSU/ Medium duration fund then there is problem as the fund has to value funds with assumed maturity of 10 years in short run. This will increase the interest rate risk as well as modified duration of the fund so the fund houses might have to reduce the exposure. This would have an impact on NAV and if you have a really large exposure, you should contemplate reducing your holdings. (Speak to your advisor/ distributor)
  • If your fund has >20% exposure & your have significant investment in such fund than consider to get out of such fund

SEBI’s regulation to rename the dividend schemes: Most people thought of dividend pay-out from their mutual fund schemes as their absolute gains. These schemes offered the tax advantage to high income tax bracket people but govt has plugged in this loop hole by taxing the dividend at the investors hand. This has made the dividend option in efficient as you have to pay tax not only on the gains but also on the money you have invested in. The new name makes it clear “Pay out of Income Distribution cum capital withdrawal option”. I flagged the incorrectness of the dividend option in Apr 2020, read it to understand the logic.

The aftermath of the Franklin verdict: The Supreme court has also accepted the liquidation approach submitted by SBI for Franklin funds. As we have already seen the partial pay-out to investors in Franklin schemes. The remaining amount of the unwound schemes should also be mostly realized by investors in the next 6-12 months in my personal view. This is quite a good outcome and shows the strength of regulations around Mutual fund structure in India. I still remember wait for 18 years and then realizing 70% of the principal amount invested in one of the deposits made by my parents. I covered the possible effect and suggested actions in aftermath of Franklin debacle in May 2020. Even though people expect a fund house risk after Franklin’s statement about exiting the country, the impact might be faced on the current liquidation process. Keep an eye on the progress and stay informed of such risks in future.

Supreme Court verdict on the interest-on-interest waiver as well as NPA Classification: Much awaited clarification came from the supreme court and it has allowed banks to declare NPAs as per existing rules with no extension on the moratorium period. This means that banks have to recognize the NPAs as well as realized the losses in accordance to the NPA recognition. Also, they have to reverse the income realized as interest on interest as prescribed by the honorable supreme court. I flagged this in Dec 2020 as risks to earnings and one of the reasons that the impact might be higher due to heightened valuation levels.

As you would have notice, There are so many moving parts that it is quite difficult to gauge the actual direction of the market. Though as I have said in past, just use the valuations as your yardstick along with your asset allocation based on goal to calibrate the exposure. In the long term, Earnings drive the markets along with future earnings expectations. The next couple of quarters would be quite important to give the actual direction of earnings and markets. Therefore, Stay vigilant and stay invested. Happy Investing!