In the last couple of weeks, there has been a major debate over AT-1 bonds after SEBI announced new valuation norms for these bonds. What exactly are these AT-1 bonds and what is the debate over the regulation?
What exactly are AT-1 bonds?
Post 2008, banks and financial institutions were allowed to raise money through AT-1 (Additional Tier-1) bonds to boost capital adequacy. These AT-1 bonds are perpetual bonds with no maturity. Technically, banks can just keep paying interest on the bonds without redeeming them. However, most AT-1 bonds have a call option after 5 years or 10 years when the bank calls back these bonds. In the past, most of the large banks had adhered to the call option model and called back these bonds after 5 years.
Why such a hue and cry over AT-1 bonds now?
As long as the issuer is a large bank with a sound balance sheet, it is OK. There is a clause in the AT-1 bond agreement that if the CET-1 (Tier-1 equity) falls below 8%, bank can skip interest on AT-1 bonds. There is no requirement to pay accumulated interest in the future too. Also, if the CET-1 falls below 6.125%, the entire principal value of the bonds can also be written off. We saw that happen in the case of Yes Bank where RBI, as part of the rescue package, wrote down the AT-1 bonds worth Rs8,450cr to zero. That is the biggest risk.
Does SEBI put restrictions on AT-1 bonds?
SEBI has already brought in restrictions on AT-1 bond investments after Yes Bank saga. SEBI has barred retail investors from purchasing AT-1 bonds. Only qualified institutional buyers (QIBs) can buy AT-1 bonds so risk awareness is there. In addition, the minimum investment ticket has been raised to Rs1cr, to ensure that only institutions with a strong balance sheet invest in AT-1 bonds.
Why has the SEBI rule on AT-1 bonds generated debate?
SEBI had passed a rule that AT-1 bonds and perpetual bonds with call option should be treated as 100-year bonds for valuation; effective 01 April. That set the cat among the pigeons because currently AT-1 bonds were being valued as 5-year bonds based on the first call option date. If mutual funds shift from 5-year maturity to 100-year maturity, it would result in huge additional provisions. It could lead to distress sale of these bonds by mutual funds ahead of Apr-21. Also, the AMC limit for AT1 bonds was pegged at 10%.
Why banks and mutual funds objected to the new AT-1 valuation rules?
Let us look at mutual funds. A shift from 5-year tenure to 100-year tenure would entail substantially higher risk and hence sharply higher write-offs. Out of the Rs70,000cr of AT-1 bonds issued by banks, close to Rs36,000cr are held by mutual funds under categories like Banking Funds, Credit Risk Funds, Medium Duration Funds etc. That would have been a huge hit for mutual funds in terms of NAV losses. For banks, losing mutual fund investments would mean losing one of the biggest ready markets for AT-1 bonds.
Are AT-1 bonds the same as Tier-2 bonds?
AT-1 bonds are classified as equity for capital adequacy and Tier-2 bonds are classified as debt or as Tier-2 capital. If the banks becomes insolvent, then Tier-2 bonds will have priority over AT-1 bonds. But Tier-2 bonds can also be written off if the bank reaches the point of non-viability (PONV) as we saw in the case of LVB. The PONV sets in if the bank gets into unsustainable losses or is bailed out by another publicly held bank.
How do I know if the debt fund I buy holds AT-1 bonds?
You have to check the portfolio of debt funds for AT-1 bond exposure. CRISIL has estimated that there are 36 debt schemes with an exposure of over 10% to AT-1 and Tier-2 bonds. Typically, these AT-1 bonds are the most popular among Banking and PSU Funds, Credit Risk Funds and Medium duration funds. When you are buying these funds, make it a point to double check the portfolio.
Has SEBI softened the AT-1 bond rules in its 22-Mar circular?
Based on representations from mutual funds and banks, SEBI issued a Glide Path for residual maturity as under.