Perpetual bonds may be valued as 10-yr debt now

The market regulator is planning to allow mutual funds to adopt a new accounting method for valuing perpetual bonds or Additional Tier 1 (AT1) bonds in their exposure books under various schemes, according to two people directly familiar with Sebi’s plans.

Specifically, from 1 April, Sebi may allow AT1 bonds to be valued as 10-year debt instruments. According to an earlier Sebi proposal, perpetual bonds were to be valued as 100-year debt papers from next month.

“It is felt that in the Indian market context at present, 100-year bond valuation method may cause to show too much risk on the books of accounts of mutual funds, which is not desirable. This may unnecessarily create a sudden redemption pressure for mutual funds since their books will get over-exposed to interest rate change risks. If the interest rates go up over such a long period of 100 years, the prices of the bonds will collapse, which will hurt the balance sheet of the bondholders. And no large bondholder would want to sell such long-term debt papers because they will be forced to sell the bonds at a steep discount in the market," said one of the people cited above.

Mutual funds own more than a third of the ₹90,000 crore of AT1 bonds that act as a crucial source of capital for local banks, according to a Bloomberg report.

Valuing AT1 bonds as 100-year debts would have not only eroded the net asset value of fixed incomes schemes offered by mutual funds but also may have forced banks to look for other means of borrowing funds to be able to sustain the growth in their lending books.

However, Sebi will change the valuation metrics for AT1 bonds in a phased manner in the coming years and, eventually, all perpetual bonds will be valued as 100-year bonds, according to the two people cited above.

The government wants the country’s banks to enhance their lending books but lacks resources to capitalize the lenders so that they are able to lend more.

This is where perpetual bonds assume significance since banks can sell such long-term debt papers to mutual funds and raise funds to be able to improve lending.

On 12 March, the finance ministry asked the markets regulator to withdraw a rule that sought to treat banks’ additional tier 1 (AT1) bonds as having 100-year maturity, making investments in them one of the riskiest, as the government feared a sell-off in these securities would make it tougher for banks to raise capital.

The department of financial services letter dated 11 March to Sebi was in response to a circular issued by Sebi a day earlier, which among other rules also limited investments by mutual funds in AT1 bonds.

The new Sebi rules that were to take effect from 1 April were aimed at reducing retail investors’ exposure to risky assets.

In October, Sebi had barred retail investors from purchasing AT1 bonds. Sebi’s decision followed the Reserve Bank of India writing off ₹8,415 crore of AT1 bonds sold by Yes Bank Ltd as part of a rescue plan.

Sebi’s 10 March circular, however, generated apprehension in the mutual fund industry that the changes would result in a revaluation of such bonds, leading to a spike in yields.

While AT1 bonds have no fixed maturity, banks have the option, but no obligation, to buy them back at specified dates.

Mutual funds have treated these dates, typically not more than 10 years, as maturity dates. Treating them as 100-year bonds would make them way riskier as longer-term bonds carry greater interest rate risk.

Mutual funds had expressed fears of a surge in redemptions by investors, anticipating losses. The relatively low liquidity of such bonds also makes them hard to sell.

Bloomberg contributed to this story.