The Securities and Exchange Board of India (SEBI)’s latest directive to restrict the exposure of mutual funds (MFs) to additional Tier I (AT1) and Basel III tier 2 bonds is a risk mitigation measure to reduce portfolio risk in debt MF portfolios. It comes after write-offs hit investors in such bonds issued by two banks in the past year.

Interestingly, Crisil’s analysis of February 2021 MF portfolios shows that none of the fund houses cross the threshold of 10% of such instruments at the asset management company (AMC) level. However, 36 schemes spread across 13 fund houses breach the cap of 10% per scheme in securities.

SEBI’s circular of March 10, 2021, caps investments by a mutual fund house under all its schemes in bonds with such special features (primarily AT1 and Basel III tier 2) to not more than 10% from one issuer. It also specifies that no MF scheme can hold more than 10% of its net asset value (NAV) of its debt portfolio in such bonds, and not more than 5% of the NAV of the debt portfolio should be due to such bonds from one issuer.

The Crisil analysis also finds that banking and public sector undertaking (PSU) fund category has the highest number of schemes (seven) exceeding the 10% cap in such securities. It is followed by the credit risk fund (five), medium duration fund (four), medium to long duration funds (four), and dynamic bond fund (three) categories.

Says Piyush Gupta, Director, Crisil Funds Research, “The regulator’s move to ‘grandfather’ limits previously held is a positive move. In the medium to long term, with the restrictions in place, it could reduce appetite among MFs for these securities, thus limiting the risk for investors. This is also prudent given the advent of hordes of individual investors in to debt funds. They may not have the ability to understand MF portfolios and gauge risk, especially in such type of bonds – we saw how they were caught unaware by the recent write-offs.”

Category-wise break-up of schemes with exposure
of more than 10% in AT1 and Basel III tier 2 bonds

Source: Crisil Research

SEBI has also directed MFs to value perpetual bonds (AT1) based on a 100-year maturity – a change from the current methodology where the call option date of the bond was considered for calculation.

This could cause volatility in pricing, especially of securities trading at a discount. It could also impact the portfolio maturity/duration considering the change of maturity date of securities to 100 years, and cause volatility in the categorisation of schemes within the specific maturity dates.

The Department of Financial Services had written to SEBI to withdraw the guidelines related to the change in valuation norms.

From an investor’s perspective, the latest move to limit exposure to these types of securities reduces the portfolio risk. Investors should continue to monitor their portfolios on a regular basis and invest as per their risk-return profiles to meet financial goals.