TThe Securities and Exchange Board of India (Sebi) in a circular today set a limit of 10% of AUM on mutual fund investment in debt with special features such as debt that converts to equity.
This includes Additional Tier 1 (AT 1) and Additional Tier (AT2) bonds, the regulator specified. Investment in a single issuer of such debt cannot exceed 5% of assets. Funds with such investments or even enabling provisions for such investments should enable side pocketing in their schemes, the regulator said. However existing investments above the limits will be grandfathered (permitted to continue) and the limit will only apply to fresh investments. The circular will come into effect from 1st April 2021.
AT1 or AT2 bonds are popularly known as ‘perpetuals’ since they do not have a fixed maturity date although banks can ‘call them in’ (repay them) at certain intervals. Such bonds are also designed to absorb the losses, if the bank’s capital dips below specific levels due to high levels of NPAs (non performing assets) for instance. This went into effect during the Yes Bank crisis in early 2020 when perpetuals written by Yes Bank were written down and mutual funds holding them faced losses. The circular also asked mutual funds to enable side pocketing if they hold such debt with special features. Side pocketing is the creation of a separate portfolio in lieu of bad debt. This allows investors to exit the remaining part of the scheme without giving up on the chance of recovery in the debt. According to the Sebi circular, a conversion of such special bonds to equity can be a trigger for side pocketing such debt, if the mutual fund wants to create a side pocket.
“I don’t think this will be a major issue for most mutual fund schemes. I think banking and PSU debt funds will see some impact as they are required to invest 80% of their assets in debt issued by banks and public sector enterprises. However the treatment of perpetuals as debt with 100 year maturity will force schemes with maturity restrictions like short term debt funds to shed such bonds. Moreover all schemes holding them will see much higher effects from interest rate movements. ” said Arvind Chari, chief investment officer (CIO) at Quantum Advisors India. The circular also laid down norms for valuation of perpetuals, stating that the maturity of such bonds shall be taken as 100 years. The regulator further barred close ended mutual funds from investing in such bonds.