YES Bank crisis: Sebi may impose curbs on MFs' exposure to perpetual bonds

The Securities and Exchange Board of India (Sebi) is likely to impose limits on debt mutual funds’ (MFs’) exposure to the additional tier-I (AT-1) bonds, with the YES Bank crisis putting the spotlight on equity-like risks involved in such instruments, according to people in the know.

According to the data sourced from primemfdatabase.com, MFs’ exposure to the AT-1 bonds — also called perpetual bonds — stood at Rs 37,687 crore as of January 31, 2020.

Classified as a quasi-equity instrument, the AT-1 bonds are intended to provide additional cushion to a bank’s overall capital adequacy. However, in terms of risk, they are riskier than tier-1 bonds. 

“After the manner in which the Reserve Bank of India (RBI) has interpreted the rights of AT-1 bondholders in the YES Bank episode, the equity-like loss-absorption features of these bonds have come to the fore. Credit risk funds of large MFs exposed to such bonds are now suddenly saddled with higher equity-like risks, as the RBI move suggests no preferential treatment would be given to these bondholders over equity shareholders,” said the chief executive officer of a fund house, requesting anonymity. 

“The market regulator will take a look at the exposure levels to such bonds in individual schemes. In some of the funds, the exposure levels are 20-30 per cent of the scheme’s assets. The regulator is likely to question such excesses,” the executive added. MFs’ exposure to AT-1 bonds has grown significantly in the past three years, more than doubling from the 2017 levels of around Rs 18,000 crore. 

 

 

According to market experts, even though the AT-1 bonds have always had a higher element of risk and trade at higher yields than the Tier-II bonds, the markets so far interpreted them to be safer than equities. “For first time, the AT-1 bonds are being written off ahead of equity. Equity shareholders will still own 51 per cent of the restructured bank, but AT-1 bondholders will suffer full loss,” said a debt fund manager. 

Under the Basel-III framework of the RBI, these bonds are superior to equity, even though information memorandums of these bonds highlight the risk of write-down or conversion to equity if a bank’s financial health is in trouble.  Market participants say that following the YES Bank episode, yields on the AT-1 bonds of other large banks have started to spike, factoring the fresh risks on these bonds.

“Whether the AT-1 bonds are issued by State Bank of India or YES Bank, the regulatory interpretation on these bonds will apply to all banks. The higher risks are already getting factored into the yields of these bonds, which are seeing spike in yields, even as the entire bond market is seeing a sharp fall in yields,” a debt fund manager pointed out. 

“Unlike the tier-II bonds, which can avail of a waterfall mechanism, the new regulatory stance shows that the mechanism will not apply to the AT-1 bonds,” the fund manager added.  A waterfall payment is a repayment system by which senior lenders receive principal and interest payments from a borrower first, and subordinate lenders receive principal and interest payments later. Experts say fund managers were caught off-guard as earlier banks seeing weak financials were able to service their bond obligations. 

“Some of the public sector banks with weak financial health and equity erosion were put under prompt corrective action of the RBI in the past, but still the AT-1 obligations were paid out fully by these banks,” a market participant said. “However, now the treatment and interpretation on the bonds is seeing a drastic change,” he said.