The finance ministry “requested” the Securities and Exchange Board of India (Sebi) Friday to withdraw the part of its Wednesday circular that changed the rules followed by mutual funds to value perpetual bonds. The capital market regulator hadn’t responded to the suggestion at press time, but is expected to review the rules before they take effect on April 1, said people with knowledge of the matter. The move by the ministry was a rare instance of such a government intervention being made public, experts said.
The ministry’s objection is to the rule that requires debt mutual funds to value perpetual bonds as a 100-year instrument from April 1. Fund managers too had raised concerns over this.
“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the capital markets, it is requested that the revised valuation norms to treat all perpetual bonds as 100-year tenor be withdrawn,” said an office memorandum to the Sebi chairman.
With the regulator yet to respond, the undertone is nervous.
Sebi is expected to review the new rules after examining the views it’s received on the issue so far. The regulator is likely to issue a revised circular before April 1, when the new rules on valuation of perpetual bonds are to take effect.
“The steps Sebi has taken are in the interest of investors. Some stakeholders may have certain concerns but Sebi’s mandate is to protect investors,” said a person close to the development. Mutual fund industry officials and lawyers said Sebi might aim for a compromise to resolve the concerns of the market and the government.
Letter highlighted impact on yields, NAVs, fund raising
“It appears to be a recommendation from the government and not a directive,” said Sandeep Parekh, founder, Finsec Law Advisors, and a former executive director at Sebi.
On Friday morning, yields on perpetual bonds – especially those belonging to smaller issuers – shot up in reaction to the circular. Some bond traders were seeking yields 20-30 basis points higher, while verbal demands had risen to as much as 80 basis points before word spread that finance ministry had stepped in. A basis point is 0.01 percentage point.
Perpetual bonds of SBI yielded 7.53%, those of Canara Bank were at 8.20%, South Indian Bank at 14.06%. Bonds of Bank of Baroda and Rural Electrification Corp (REC) also changed hands at 7.69-8.13% during the day. Yields were up by about 10 basis points for reported deals.
Fund managers said attempts to sell the perpetual bonds of smaller issuers in morning trade were unsuccessful in the absence of liquidity. Many mutual funds were understood to have sold some of their liquid bonds to be ready for any possible redemption pressure in schemes that hold perpetual bonds. Industry executives said redemption requests were modest on Friday with the finance ministry note easing frayed sentiment.
“Mutual funds were building a cash chest by selling some liquid securities. Nobody wants to be in a situation like what happened during Franklin Templeton,” said a senior mutual fund industry participant.
The finance ministry letter highlighted the adverse impact of the rule on bond yields, net asset value (NAV) of debt mutual funds and fund raising by public sector banks.
“Panic redemption by mutual funds would impact overall corporate bond market as MFs may resort to selling other bonds to raise liquidity in debt schemes,” the letter said. “This could lead to higher borrowing costs by corporates at a time when economic recovery is still nascent.”
Mutual funds are among the biggest holders of perpetual bonds. They currently hold more than Rs 35,000 crore of the outstanding Additional Tier 1 issuances of about Rs 90,000 crore, the letter said.
The debt scheme categories that hold this instrument include banking and PSU funds, dynamic bond funds and credit-risk funds among others with up to five-year maturity. Hybrid funds also hold such bonds.
Perpetual bonds have a five-year call option, which allows holders to exit instead of staying invested permanently. Fund managers had opposed the latest Sebi rule as it required debt schemes to value this security as a 100-year paper instead of a valuation assigned to a shorter maturity. This could result in yields on perpetual bonds shooting up and prices falling, causing losses to holders. Bond yields and prices move in opposite directions.
With the capital market regulator changing the valuation rule, bond traders were expecting a surge in yields of as much as 100 basis points. Banks, major issuers of perpetual paper, would have faced higher costs in seeking to raise funds through the avenue. Banks were said to have been preparing to approach the Reserve Bank of India seeking relaxation of the norms. They have issued nearly 93% of total outstanding perpetual bonds, pegged at Rs 1.46 lakh crore, show data compiled by JM Financial.