All you need to know about the AT-1 bonds controversy

In the second week of March, SEBI issued a circular on updated valuation norms for perpetual bonds. The proposal was strongly objected by the finance ministry.

Additional Tier-1 bonds, aka AT-1 bonds are a type of unsecured, perpetual bonds that do not carry any maturity date as bonds usually do. Instead, the issuer (specifically banks) offer to pay a coupon, i.e. fixed interest on them for eternity. 

Note: AT-1 bonds are a part of a bigger group of bonds known as Perpetual Bonds. These bonds do not have a maturity date. They can be continued for as long as the issuer desires, just like equity shares.

Please keep in mind AT-1 bonds and perpetual bonds could be used interchangeably as the policy update is for perpetual bonds but major chunk of these bonds are AT-1 bonds, so its one and the same thing.

In the second week of March, SEBI issued a circular on updated valuation norms for perpetual bonds. The proposal was strongly objected by the finance ministry.

What did the circular say?

Debt mutual fund’s exposure to perpetual bonds capped at 10%

After the previous year’s Yes Bank saga and the write-off of the AT-1 bonds issued by them, which hugely affected the bondholders and debt mutual funds, SEBI decided to cap debt mutual fund’s exposure to perpetual bonds (consisting of AT-1 bonds and Tier 2 bonds) to a limit of 10%. This was done in order to protect retail investors participating in debt mutual funds.

Valuation of such bonds to be done as per 100-year maturity duration

The security market regulators have also laid down that mutual funds need to value such bonds as per 100-year maturity instead of the current 5 to 10-year maturity. The purpose behind this was that at the current valuation, the return that the bond provides seems extremely attractive and does not reflect the true risk. This leads even retail investors to get trapped by investing in such bonds without knowing all terms and conditions.

These changes were to be implemented starting from April 01, 2021.

Good move in favour of the public, isn’t it?

What is the concern then?

• Today, fund houses value perpetual bonds assuming that their issuers will exercise their call options five or ten years from the issue date. 

• But SEBI wants fund houses to change valuation assuming that the principal will be returned only a 100 years later.

• Following this tweak in norms, these bonds will become ultra long term. The current coupon rate provided on these bonds will seem less attractive for the 100 years investors and mutual funds may have to hold them for. The increased risk will lead to less demand which implies lowering prices.

• Also, selling by debt mutual funds in order to adhere to the new exposure limit will add more pressure leading to volatility in the prices and increasing yields.

• Not only will this change in valuation norm lead to significant volatility in the NAVs of several debt schemes, but the calculation can itself be cumbersome.

• Decreased value of AT-1 bonds and the exposure limit will make it difficult for banks to raise capital. AT-1 bonds have been a go-to capital raising security instrument for banks from the 2008-09 financial crisis.

• Think about what will the government do as they are planning to raise capital through the public sector banks. Instead, the PSU Banks will become more dependent on the government for capital. The Finance Ministry immediately raised concern against the circular.

• What about retail investors? While the fund houses have their work cut out, investors in debt schemes will have to face the volatility too, if they are into schemes with large perpetual bond exposures.

Ten days later, SEBI mends valuation norms on AT-1 bonds after FinMin raise concern

The SEBI circular said, “Based on the representation of the Mutual Fund Industry to consider a glide path for the implementation of the policy and on the request of other stakeholders, it has been decided that the deemed residual maturity for the purpose of valuation of existing as well as new bonds issued under Basel III framework shall be as below:

Tip: Do not be intimidated by words ‘deemed residual maturity’. It just means that the leftover duration of the bond.

           *100 years from the date of issuance of the bond

(table source: https://economictimes.indiatimes.com/mf/mf-news/sebi-amends-valuation-norms-on-at-1-bonds-after-finmin-push/articleshow/81637280.cms)

• As the above table mentions, the leftover duration will be assumed to be 10 years till 31 March, 2022 on the condition that some of the bonds used for raising capital are redeemed. If that is not done by the banks then their AT-1 bonds will be immediately valued at 100 years maturity from the date of issuance.

• For the time from April, 2022 to September, 2022 maturity period will be taken as 20 years and from October, 2022 to March 2023 it will be taken as 30 years.

• And finally from April 01, 2023 the leftover time period or duration of the bond will be 100 years from issuance of the AT-1 bond.

Earlier the circular mandated the valuation to be updated to 100 years by April 1, 2021. If that would have stayed then the debt schemes that have higher exposure to thinly traded perpetual bonds (like AT-1 bonds or Tier 2 bonds) would have to wind down this exposure or revalue these bonds causing NAV blips.

A CRISIL Research report has found that 36 debt schemes from 13 fund houses held more than the SEBI-mandated limit of 10 per cent in perpetual bonds. (source: https://www.thehindubusinessline.com/opinion/columns/slate/all-you-need-to-know-about/article34134365.ece)

Right now it seems that the situation has calmed down the latest modification seems to have satisfied all parties.

Stay inquisitive!

Written by: Aastik Pasricha

Disclaimer: This blog is only for educational purpose and in now way intends to propel anyone to invest in the securities mentioned above. Any investment decision should be your own based on consultation with your financial advisor and dear ones. Investing or trading involves risks thus, make decisions accordingly.