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.

Mutual Fund

ICICI Pru Eq & Debt: A Fallen Angel?

More often my advise, to the new investor, has been to use the aggressive hybrid funds (earlier named Balanced funds) as their first equity funds. Aggressive hybrid fund category is also been advocated by me to be part of your core portfolio. In most of the recommended mutual funds lists over the years, ICICI Prudential Eq & Debt has been an integral part. Though in last couple of months, it has received lot of attention for the said transfer of lower quality bonds from credit risk funds to hybrid fund. Recently in the Mint 50 list of mutual funds, it was replaced by another fund. Similarly, another most followed mutual fund site VRO has dropped an star from this fund to make it a 3-star fund. Since I also had this fund in my list of pick in the aggressive hybrid funds, Some of you reached out to me to share my point of view on this fund. I will share my point of view from the perspective of fund profile, historical performance, peer comparison and future expectations.

You can read more about Core & Satellite Portfolio or Aggressive hybrid fund category.

The original fund was launched in Nov 1999. In little over 20 years, the 10,000 invested in the fund would have grown by 12.62x with a CAGR or 13%+. To compare, the pure equity index Nifty 50 TRI returns over the same period are ~10% only. Aggressive Hybrid fund is the example of much touted 60-40 strategy of investing that it works. The fund has the expense ratio of 1.2% and has the 2nd highest AUM of 17,600+ crore in the Category. Currently fund is managed by two of the prominent fund managers in India Manish Bhatia & S. Naren. Both the fund managers bring their combined investing experience of 40+ years.

Lets dive down to see if not this fund that what are our alternatives. I compared the funds in aggressive hybrid category with at least 5 years of history & 100 cr of AUM. The top pick Mirae Asset Hybrid has an advantage of lower expense ratio over other funds, helping it to give better returns. Though it is gaining the AUM and the expense ratio would normalize back to average in category of 90bps, the fund might succumb to lower performance. Though our top picks from last round in 2019 Canara Robeco Hybrid & SBI Eq Hybrid continues to be the performer with lower draw downs. Even though the performance of the ICICI Pru Eq & Debt has dropped but it continue to be in the top half of performers.

Lets talk about its approach, This is one of the only fund in the aggressive fund category which has a higher bend towards value style vs others. Value as a category is currently a more prudent approach given all the questions about valuations and stress in economy. Will it help in out-performance? only future will tell, we will see.

Regarding the debt investment, where the most noise about the fund holding majority of debt portion in AA rated papers. Is that really risky? From credit risk perspective, it is risky. If you take a closer look, unrated paper is an InvIT. InvIT in current environment a great source of stable income. Most of the other papers are from Banks & PSUs which are psuedo goverment backing. Yes there are couple of bonds to question about, though 1% swing in a equity fund is like any other day. One thing which very few people notice or talk about is the duration of the debt fund portfolio. ICICI Pru has the modified duration of <2years vs other funds with duration of 3-5 years, This is very well positioned for the end of rate lowering cycle. If the interest rates risk over next 2-3 years, other funds will have the -ve impact.

All in summary, If you are a new investor and still about to start your investments then take a pick between Canara Robeco Eq Hybrid or SBI Eq Hybrid. If you are knee deep in this fund already, then there is no need to jump of the ship and your patience/ loyalty would most probably be awarded suitably. Keep investing!

If you have the similar question about HDFC Eq Hybrid, do check its review. Also, Don’t forget to check our new section of experienced voices, for learnings’ from other fellow investors experience.