Additional tier 1 bonds are perpetual debt instruments that cannot be redeemed at the option of the holder and carry fixed coupon. They are issued by banks which do not have a maturity date and are, hence, called perpetuals but have higher risks.
On the other hand, additional tier 2 bonds are one-two notches above AT 1 bonds of a bank and therefore have high loss-absorption features.
The Reserve Bank had opened up these bonds for retail investors about six years ago, with certain conditions that ensured investors were well educated of the ‘loss-absorbency’ risk of these bonds. The relatively lower risk in tier 2 bonds compared to tier 1 bonds is reflected in the ratings.
Mutual funds value these bonds as if they are maturing on their call date—the date on which the issuer may call back bonds and repay their holders, but there is no compulsion on the issuer to do so.
Amidst the ongoing Franklin Templeton fiasco, the markets watchdog Sebi had on March 10, asked mutual funds to restrict their exposure to additional tier I & 2 (AT1 & AT2) bonds to under 10 per cent to reduce their risks in debt fund portfolios, in its bid to mitigate risks of retail investors.
The regulatory move came after the huge write-offs hit investors in such bonds issued by two banks in the past year.
However, it has been found that none of the fund houses holds more than 10 per cent.
“Our analysis of February 2021 MF portfolios shows that none of the fund houses cross the threshold of 10 per cent of such instruments at the asset management company (AMC) level. However, 36 schemes spread across 13 fund houses breach the cap of 10 per cent per scheme in securities,” Crisil said in a note on Sunday.
But the agency said the Sebi move will mitigate risk in debt portfolios for retail investors.
The Sebi circular has also specified that no MF scheme can hold more than 10 per cent of its net asset value (NAV) of its debt portfolio in such bonds, and not more than 5 per cent of the NAV of the debt portfolio should be due to such bonds from one issuer.
Crisil said its analysis has also found that banking and public sector undertaking (PSU) fund categories has the highest number of schemes (seven) exceeding the 10 per cent cap in such securities.
It is followed by the credit risk funds (five), medium duration funds (four), medium to long duration funds (four), and dynamic bond funds (three), Crisil said.
Accroding to Piyush Gupta, a director at the agency, the regulatory move to ‘grandfather’ limits previously held is a positive move.
“In the medium to long-term, with the caps in place, it can reduce the MFs‘ appetite for these securities, thus limiting the risk for investors. This is also prudent given the advent of influx of individual investors in to debt funds.
They may not have the ability to understand MF portfolios and gauge risk, especially in such type of bonds, we saw how they were caught unaware by the recent write-offs,” he said.
In a radical shift from the current methodology where the call option date of the bond was considered for calculation, the regulator has also directed MFs to value perpetual bonds (AT1) based on a 100-year maturity.
Gupta said this may create volatility in pricing, especially of securities trading at a discount. It can also impact the portfolio maturity/duration considering the change of maturity date of securities to 100 years, and cause volatility in the categorisation of schemes within the specific maturity dates.
Considering the massive impact it can have, the finance ministry had asked Sebi to withdraw the guidelines related to the change in valuation norms.
But from an investor’s perspective, the latest move to cap the exposure to these types of securities reduces the portfolio risk.