The Centre has ordered Sebi to withdraw parts of a controversial circular that the market watchdog issued on Wednesday that sought to treat perpetual bonds issued by banks as instruments with a 100-year tenure.

The move had sent shock waves through the bond market as it raised the prospect of massive mark-to-market losses for investors.

The department of financial services (DFS) issued a letter to Sebi asking it to rescind the 100-year valuation rule as it could disrupt the bond market and undermine the efforts of banks to raise additional funds through additional Tier-1 bonds (AT-1 bonds) to beef up their capital base.

AT-1 bonds are considered to be issued in perpetuity, similar to equity shares as per the Basel III guidelines on capital adequacy. They form part of tier 1 capital of banks.

The Sebi circular, which was due to come into effect from April 1, also imposed prudential limits on mutual fund investments in these bonds which will remain.

The new limits will constrain the ability of mutual funds to load up on AT-1 bonds and will lead to a rise in coupon rates, the DFS said in its office memorandum issued to the Sebi chairman and the economic affairs secretary in the finance ministry.

“Considering the capital needs of banks going forward and the need to source the same from the capital markets, it is requested that the revised valuation norms to treat all perpetual bonds as 100 year tenor be withdrawn,” the memorandum said.

North Block, however, said instructions that reduce concentration risk of such instruments in MF portfolios can be retained as fund houses have adequate headroom even within the 10 per cent ceiling,
Mutual funds have bought Rs 35,000 crore worth of AT-1 bonds out of the Rs 90,000 crore issued by banks, almost 40 per cent of the issuances. They would suffer massive mark-to-market losses if this guideline was implemented.

“The clause on valuation is disruptive,” a note written by DFS to Sebi on Wednesday said. It argued that there is no benchmark for 100-year bonds in India. AT-1 bonds are popular with debt mutual funds because of their high interest rates. But they run the risk of getting converted to ordinary shares or even be written-down if a bank’s common equity Tier-1 (CET1) ratio falls below a certain threshold.

Banks can also skip coupon payments. Investors, in fact, had a harrowing experience with the paper when Yes Bank wrote down such bonds worth Rs 8,415 crore.

But it was the capital market regulator’s move to treat the bonds as 100-year paper for valuation purposes that rankled the government, mutual fund players and banks.

Since these instruments are perpetual bonds, debt mutual funds value them to the call option date. For instance, if a bank issues a perpetual bond, the call option may be exercised after 10 years. Sebi’s current rules on valuation of such securities that have a call date say they should be done “at the lower of the value as obtained by valuing the security to final maturity and valuing the security to call option’’.
Sebi’s latest directive meant they will have to be valued at 100-year maturity. Mutual fund circles say this will directly mean a lower valuation of these bonds.

Banks would also see the yields inching up and raising their cost of mobilisation. As per the current RBI rules, banks can raise 1.5 per cent of their risk weighted assets (loans) through such bonds.

“The Sebi circular (if it comes into effect) will make the valuation of such a perpetual instrument (quasi- equity in nature) to go haywire as the tenor of such bonds, instead of being perpetual, will be 100 years,” according to Uttara Kolhatkar, partner, J Sagar Associates.

“This directive would have had a cascading effect on the bond market and increase volatility. Potential redemptions on account of this new rule would lead to mutual fund houses engaging in panic selling of the bonds in the secondary market leading to widening of yields.”

Sebi had also fixed certain holding limits: no mutual fund can hold more than 10 per cent of such instruments issued by a single entity across all its schemes. An MF scheme shall not invest more than 10 per cent of the net asset value (NAV) of its debt portfolio in such instruments. Besides, an MF scheme should not invest more than 5 per cent of the NAV of its debt portfolio in a single issue.

Deepak Shenoy, founder of Capitalmind, said in a blog post the AT1 market will not see that much enthusiasm from mutual funds. He said the limits on percentage owned and the rules against holding them in term based funds such as low duration funds or ultra short-term funds will lead to lower demand. This, he added, should hurt the price in the market for AT1 bonds.

The circular may have begun showing its impact on some of these perpetual bonds. For instance, yields on SBI’s 7.73 per cent bond were trading at 7.53 per cent against 7.28 per cent on Tuesday.

The Association of Mutual Funds in India (Amfi) said it was in discussion with Sebi to make sure there is a smooth implementation of the circular and it fully supports the “need and spirit” of the circular in capping exposure to perpetual bonds.

Most of the mutual fund schemes are well below the cap specified in the circular. In few of the schemes where perpetual bond exposure is higher than the Sebi prescribed cap, grandfathering is kindly permitted by Sebi to ensure that there is no unnecessary market disruption,” it said.

Funds to banks

The finance ministry is likely to infuse Rs 14,500 crore mainly in the banks that are under the RBI’s prompt corrective action framework in the next few days to improve their financial health.

Indian Overseas Bank, Central Bank of India and Uco Bank are under this framework that puts several restrictions on them, including on lending, management compensation and directors' fees. The ministry has almost finalised the names for capital infusion, sources said.

The infusion will be made in the next few days, the sources said, adding the biggest beneficiary of this round of capital infusion would be the banks that are under the prompt corrective action (PCA).

The capital infusion will help these banks to come out of the Reserve Bank of India's enhanced regulatory supervision or PCA framework. Most of the large state-owned lenders -- including State Bank of India,

Punjab National Bank, Bank of Baroda, Canara Bank, Union Bank of India, and Indian Bank -- have already raised money from various market sources, including share sale on a private placement basis.