The securities market regulator SEBI on March 22, 2021 allowed mutual funds a ‘glide path’ or a phased implementation of its earlier announced 100-year maturity rule for valuation of perpetual bonds. This offers some relief to mutual funds.

All existing Basel III AT-1 bonds (perpetual bonds), and the new ones issued until March 31, 2022 will be deemed to have a 10-year maturity to start with. Thereafter, the maturity of the existing bonds will be upped to 20 years from April 1, 2022, to 30 years from October 1, 2022 and to 100 years from April 1, 2023 onwards.

Newly issued bonds will be deemed to have the maturity depending on the time-period of their issue and will then be upped accordingly as per the above norm. Basel III Tier II bonds will be valued assuming a 10-year maturity or the actual maturity of the bond, whichever is earlier ( see Table 1)

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Perpetual bonds: MFs heave a sigh of relief

What it means for investors

Today, these bonds are valued based on when they will be called (say three or five years from now, for example). Once the same bonds are assumed to have a 10-year maturity, they become less valuable than before. As a result, the prices of such bonds will fall, and their yields will rise. According to a few financial advisors we spoke to, yields on many of these bonds (some data available on NSE) have already seen a rise.

MF schemes that have significant investments in such bonds are therefore, expected to experience a drop in their NAVs on April 1, when the new norms come into effect. This will be due to the mark-to-market loss on bonds as they get revalued based on the 10-year maturity rule.

Here are a few points for investors to note.

One, with the 100-year rule deferred to April 2023, the drop in NAVs is expected to be milder than originally anticipated, especially for schemes where the exposure is not significant (5-10 per cent, for instance). So far, even of the 18 MF schemes that have more than 15 per cent of their assets under management invested in perpetual bonds as of February 2021 (based on CRISIL data), only IDBI Hybrid Equity Fund has experienced a 2.23 per cent drop in NAV since March 10, 2021.

As on February 28, 2021, IDBI Hybrid Equity Fund had 14.66 per cent of its net assets in Basel III AT-1 bonds of Bank of Baroda and Punjab National Bank. The NAVs of other schemes have changed only marginally.

Two, even for schemes where the exposure is high, if it is to bonds of leading banks such as State Bank of India, ICICI Bank, Axis Bank, HDFC Bank, there may be less cause for concern.

All you need to know about perpetual bond controversy

According to Joydeep Sen, a corporate trainer (debt markets) and author, while the yields on bonds issued by these banks may go up (as there will be depressed demand from MFs which account for one-third of the total demand) and impact the scheme NAV in the interim, as long as the banks continue to pay interest and redeem their respective bonds on the call date, it will not impact the scheme returns in the long run. This is because these bonds will be redeemed by banks at their face value irrespective of their valuation.

While depressed demand in future (and some selling too) for perpetual bonds from MFs may exert pressure on their yields (and prices), this may not turn out to be very significant. According to Lakshmi Iyer, President and Chief Investment Officer (Debt) & Head Products, Kotak Mahindra AMC, while MF demand could be tepid, there could be other sets of investors who could find favour with such instruments. The glide path to maturity date recognition too helps in smooth implementation of the circular, according to her.

Investors with a low risk appetite, however, need to reconsider their investments where the scheme exposure to perpetual bonds is high (say 15 per cent and above) and such a scheme (or schemes) forms a large portion of their debt portfolio.

With the new valuation norms on perpetual bonds, there can be greater near-term volatility in yields.

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