Is investing in banking & PSU debt funds entirely safe?

R Balachandran, an expert in credit risk and debt mutual fund investments, says investors ought to be aware of the risk arising out of exposure to Additional Tier 1 bonds, while investing in banking and PSU debt funds.

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The April RBI monetary policy review kept the benchmark repo rate unchanged while increasing the reverse repo rate by 0.25%, sounding a hawkish tone in general on inflation risks. Predictably , 10-year Gsec rates went up. Pundits appear to be veering around to the consensus that interest rates have only one way to go, which is upward. There is also a contrarian view which recommends fixed income investing, which is a punt on lower interest rates.Investors therefore are in a quandary on the direction of rates and timing of any possible hikes. Credit risk in debt mutual funds adds another uncertainty to the equation with the recent blow up in the debt schemes of a fund house.

It would therefore appear that investors would do well to seek safety in pseudo sovereign bank CD funds which go under the name of banking and PSU debt schemes. Many of them offer schemes of intermediate duration which makes them a safer play in today's uncertain interest rate scenario. YTM's of some of these schemes are quite attractive, with some touching 8%. Credit risk is predicated on a portfolio predominantly of banking and public sector entities. Inflation beating returns from an impeccable set of issuers! Sounds too good to be true? The catch lies in Additional Tier 1 bond investments offering a higher yield issued by weak PSU banks, which some schemes have gorged themselves on.

Additional Tier 1 (AT1) bonds are issued by banks for perpetuity i.e.they do not have a fixed repayment date. The Bank of International Settlements (BIS), Basel, stipulates 14 criteria for AT1 bonds to be considered as part of a bank's Tier 1 capital. The Basel rules effectively makes this a quasi-equity instrument, passing on coupon payment risk entirely to investors with the coupon payments subject to availability of distributable reserves. The Reserve Bank of India stipulates triggers, based on which investors will have to absorb losses on these bonds if the Common Equity Tier 1 capital falls below a specified percentage of Risk Weighted Assets. RBI has also unequivocally affir med the Basel Committee's norms that banks should have full discretion at all times to cancel distributionspayments.

Analysis of the portfolio of banking and PSU debt funds managed by some fund houses reveals significant exposure to AT1 bonds of weak PSU banks. A plain vanilla fixed deposit of a retail investor in such banks carries negligible default risk even if the amount invested exceeds the Rs 1-lakh cover provided by the DICGC. If one bank defaults, the contagion would affect the entire PSU banking sector. No government would risk this. But the AT1 bonds are a different ball game all together. Investors are a handful and are predominantly institutional or high networth individuals. RBI governor Urjit Patel, in the April 2017 monetary policy review meet, lamented about the moral hazard in bailing out farmers stuck with agricultural loans. Farmers constitute an important political base, while a handful of institutions or HNW investors do not make or break elections. A “bailout“ is effectively ruled out for any prospective coupon payment default on AT1 bonds by a weak PSU bank. Nor would RBIBasel norms permit it.

Investors need to be cognizant of this risk arising out of exposure to Additional Tier 1 bonds, while investing in Banking and PSU debt fundsother debt fund schemes.IRDA, the insurance regulator has come out with guidelines on the minimum rating (AA) for investment in AT1 bonds by insurance companies.SEBI can similarly consider regulating credit rating etc. for AT1 Bond investment by debt mutual funds to prevent undue risk taking.