Retail investors are the last to know when things go wrong with their money. This is especially true of difficult-to-value-and-trade (in India) financial products such as bonds. The story gets even more complicated on how to treat bonds that behave like (or worse than) equity – for example AT1 bonds. AT1 bonds are issued by banks to shore up core capital base to meet BASEL III norms. These are unsecured, perpetual, high-risk bonds. Banks can skip paying interest on these bonds if their capital ratios fall below certain threshold level. These bonds are junior to equity and get extinguished in case of a bank failing. In English this means that these bonds need not pay interest and need not return capital if the bank finances are under stress. Retail investors into Yes Bank AT1 bonds lost their entire savings when they bought these bonds when they were told by the bank managers that these were FDs with a higher interest.
Mutual funds also have AT1 bonds in their debt funds, introducing risk worse than equity into products that retail investors consider safe. These risks were marked out in this story in 2016. One estimate says that there were 25 schemes by end June 2020 with between 15% to 60% of their assets in these risky bonds. That’s a lot of very high-risk bonds in a debt portfolio!
A March 10, 2021 circular issued by Sebi lays out the rules of the game so that worse than equity risk is not introduced into debt funds. The circular says:
- No mutual fund will own more than 10% of these bonds issued by a single issuer across all its schemes.
- Not more than 10% of a scheme to be invested in these bonds.
- And not more than 5% of a scheme in the bonds of a single issuer.
- If a scheme and fund house already have investments that are higher than these limits, these will be grandfathered – the fund need not sell them, but not buy more.
For retail investors this is important because Sebi is putting limits on how much of these very risky bonds a fund house can buy. And for funds that are already holding more bonds than now allowed, Sebi is giving a leeway of ‘grandfathering’ their holdings. They are not being forced to sell, but cannot buy more till they fall below the new regulatory thresholds.
A second part of the circular says that:
- The tenor of the bonds will be considered as 100 years since they are, well, perpetual.
- Closed end schemes will not invest in perpetual bonds, because they will not have a tenor of a 100 years
Sebi’s goal seems to be to protect investors into debt funds from finding too much risk in their portfolios. Some debt funds were found to be treating these long-term bonds as short term by taking the put and call dates as the tenor of the bond. Put and call dates are those dates on which the bank can call back these bonds and pay investors back or investors can sell these bonds back on a ‘put option’ date. See this from an investor point of view, you buy a short-term debt fund to have certainty of money and a return that is slightly higher than a bank deposit. But to include highly risky, long-tenure bonds in the portfolio of short term bonds, as Franklin Templeton did, makes investors open to risks they did not want to take. Also valuing a perpetual bond on the call/put date is a real sleight of hand and a very sharp practice by the fund houses doing this.
This action by Sebi is in continuation to its October 2020 circular that put in place rules so that retail investors cannot buy these bonds directly. A minimum ticket size of Rs 1 crore, a minimum lot size of Rs 1 crore and restricting sales to only institutional buyers were all aimed to preventing a Yes Bank like mis-selling episode. Surprisingly, action was taken by the capital market regulator to what is a banking regulator problem. RBI took the view that retail investors were disclosed the risk of these bonds by Yes Bank and were not mis-sold. This paper (I am one of the authors) marks out how better disclosure would have prevented most of these sharp sales by Yes Bank officials.
But things unraveled on 12 March 2021 when the Department of Financial Services, Ministry of Finance overruled Sebi and in a memorandum as reported in the newspapers, told Sebi to withdraw the valuation rule as it would lead to market disruption. Next, the industry body Association of Mutual Funds in India (Amfi) made a press statement standing with Sebi! Amfi, actually has no option but to do this since these issues have been debated and discussed for months before the circular was issued two days back. The issue of AT1 bonds in mutual fund portfolios and how to value them has been a subject of much discussion within Sebi and with the mutual fund advisory committee (I am a member on this committee) over the past few months.
The Ministry of Finance has done two things wrong. One, it has not seen the retail investor interest in the action of Sebi and seems to be responding to the banking lobby. Two, by undermining the regulator in this manner it is setting a precedent for others to follow by messaging Delhi directly rather than work with sector regulators. It would have been better semantics had the government resolved the issue rather than take it public in this manner. Very unfortunate for retail mutual fund investors in particular and regulatory autonomy in India in general. The finance minister Nirmala Sitharaman needs to set this right.