Bond storm

The Securities Exchange Board of India’s circular to streamline ownership and valuation of Additional Tier-1 bonds and other perpetual instruments by debt mutual funds has stirred up an avoidable controversy. It tightens the screws in two ways. One, it specifies that no debt fund should invest more than 10 per cent of its Net Asset Value (NAV) in perpetual bonds and over 5 per cent in a single issuer from April 1. This is fair . With features that allow issuers to skip interest payouts and write-down principal, perpetual bonds are closer to equities in risk profile than debt. In fact, it is questionable if they belong in debt fund portfolios at all. With some funds burning their fingers in YES Bank and Lakshmi Vilas Bank, SEBI appears right in curbing their future exposures, while grandfathering their legacy holdings. Two, SEBI has also introduced new valuation rules that require funds to value perpetual bonds on traded prices, or if not traded, treat them as if they carry a 100-year maturity. The industry’s present practice of valuing perpetual bonds based on their call dates unrealistically plays down risks and inflates fund NAVs.

This well-intentioned circular however seems to have drawn the ire of the Finance Ministry, which has promptly written to the regulator to retract its new valuation rules. Its contention is that with mutual funds sitting on perpetual bonds valued at ₹35,000 crore, the abrupt change could lead to NAV losses, trigger redemptions and unleash general mayhem in the bond market. The larger fear is that it will make it difficult for banks to find subscribers for their perpetual bonds in future. While the Ministry could have avoided going public with its objection which undermines SEBI, it does have a point on valuation. If the industry practice of valuing perpetual bonds as 5- or 10-year bonds smacked of over-optimism, treating them as 100-year bonds errs on the side of ultra-conservatism and exposes fund investors to unusual NAV volatility. Given these implications, one wonders why SEBI, taking a cue from IRDA, did not limit these exposures from the outset or work out a compromise valuation formula that strikes a middle path. The Ministry, on its part, needs to accept that while banks need to find buyers for their future perpetual bond issuances, retail investors are far from a suitable target for them; SEBI is, anyway, the best judge of such suitability.

A workable solution could be for SEBI to allow mutual funds to launch new categories of high-yield or hybrid schemes for corporates and high net worth investors which have more liberal exposure limits. The fund industry, on its part, needs to stop constantly testing the regulatory boundaries with its sharp practices and adhere to some self-discipline. The IL&FS, DHFL and Franklin Templeton episodes have already dealt a body blow to the reputation of debt funds from which the industry will take a long time to recover.

COMMENT NOW