In the last two weeks, there has been a lot of buzz around SEBI's proposed norms on debt instruments with special features such as the Additional Tier 1 (perpetual bonds) and Tier 2 bonds. You can read about its details over here.
To provide a broad summary, in a circular dated 10th March, SEBI had capped a mutual fund's exposure to such debt instruments to 10 per cent of its AUM and it also mandated that the schemes with exposure to such bonds will have to ensure enablement of the side-pocketing provision in their information document. Further, SEBI had proposed a regulation regarding valuing perpetual bonds as 100-year instruments from the date of their issuance. Typically, the call-option date was used by funds for valuing these bonds.
While cap on exposure to Tier 1 and 2 bonds was in the right spirit, the proposed changes to the valuation norms for perpetual bonds were contentious. It didn't go quite well with the fund industry as it anticipated significant NAV erosion in the funds having exposure to perpetual bonds. Calling the valuation norms fairly disruptive, even the finance ministry reportedly asked SEBI to roll back the 100-year maturity rule.
In line with the expectations, SEBI on Monday released a clarification on the valuation of bonds issued under the Basel III framework. While the regulator didn't withdraw the rule, it has proposed a staggered implementation of the valuation guideline. In the current framework of things, funds will treat perpetual bonds as 10-year papers till 31st March 2022, then as 20-year papers for the next six months till 30th September 2022, and then as 30-year instruments over the subsequent six months and finally as 100-year instruments from 1st April 2023. This will apply to both existing as well as new bonds issued under the Basel III framework.
Meanwhile, for Tier 2 bonds, till 31st March 2022, their maturity will be either 10 years or the contractual maturity, whichever is earlier. Thereon, the contractual maturity will be used for valuation.
The staggered implementation of the 100-year maturity rule definitely alleviates the concerns of panic-selling from fund managers. Further, the calibrated approach will give more time to mutual funds for an orderly adjustment to the new valuation norms. Despite that, the coming in of these norms might reduce the demand for such bonds by mutual funds.
The circular also states that in case an issuer doesn't exercise the call-option for any bond, the valuation would then have to be done using the 100-year maturity rule from the date of issuance for Tier 1 bonds and using the contractual maturity for Tier 2 bonds, for all bonds of the issuer. In addition, if the non-exercise of call-option is on account of financial stress of the issuer or if there is any adverse news, the same should get reflected in the bond valuation. Further, the watchdog has asked AMFI to issue detailed guidelines with respect to valuation of bonds issued under the Basel III framework, which will be implemented by 1st April 2021.
