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    SEBI's New Rules for AT1 Bond Valuations, Explained

    Editor, TRANSFIN.
    Mar 24, 2021 5:14 AM 5 min read

    India’s banking industry has been on edge the past two weeks. To be fair, when is it ever not?

    The Ides of March

    The apprehensions stemmed from a March 10th SEBI circular which directed mutual funds to price Additional Tier-1 (AT1) bonds using 100-year valuation norms. We’ll get to what this means in a minute, but this rule was supposed to go into effect on April 1st 2021.

    Markets expressed alarm at the implications of the above move:

    • Yields of many of these AT1 bonds went through the roof.
    • Mutual funds and banks protested.
    • Some lenders deferred new bond issuances to avoid paying high yields.
    • The Department of Financial Services said that the revised norms could lead to huge "mark to market losses" for investors.
    • The Finance Ministry warned that “capital raising by PSU banks from the market will be adversely impacted”.
    • And finally, the Government asked the regulator to withdraw its circular.

    In response, SEBI relaxed its stance. In a statement released yesterday, it said AT1 bonds' maturity would be 10 years until March 31st 2022 and the 100-year rule would kick in only from April 2023.

    The regulator didn’t actually rescind its circular but only deferred its implementation by two years. This has calmed nerves nonetheless, even if temporarily. But these developments have brought to the forefront the AT1 bond, a debt instrument that was already eliciting raised eyebrows thanks to the Yes Bank episode.

    But first...

     

    A Brief Brief on Bonds

    A bond is a loan. When you buy a bond, what you’re doing is lending money to the entity that is issuing a bond (e.g. a company, bank or the government). This entity issues bonds to raise capital. Issuances can rise during times of crises...like a pandemic. Remember how corporate bond issuances reached a record high in FY21?

    Now, to thank you for your investment, the issuer may pay you interest payments periodically until the bond matures. As is with a loan, once a bond reaches maturity, the issuer of the bond repays the principal to the investor.

    Two important things to note here. One, for longer-term bonds, the interest rate is typically higher. And two, bond price and yield are inversely related. (For a deep-dive into bond basics, read this.)

     

    What are AT1 Bonds?

    AT1 bonds are unsecured bonds with a perpetual tenure i.e. They don't have a predetermined maturity date. This is why they are clubbed under perpetual bonds.

    However, these instruments do have a call option that can be used by the issuers to buy them back from investors.

     

    Basel Basics

    AT1 bonds became popular following the Great Recession, when several major banks went bust. To prop up better safeguards, the Basel III norms took shape. Under the updated rules, Indian banks were required to maintain a Total Capital Ratio (CAR) of 11.5%, split between 9.5% in “Tier 1” capital and 2% in “Tier 2” capital.

    FYI: Tier 1 refers to a bank's core capital, equity and the disclosed reserves that appear on the lender’s financial statements. This is also known as permanent capital. Tier 2 includes a bank's supplementary capital, such as undisclosed reserves and unsecured subordinated debt instruments.

    AT1 bonds, as their name suggests, are considered a part of a bank’s Tier 1 capital (usually reserved for equity), even though they are more debt-like.

     

    Risky Business

    Besides the unspecified maturity and the call option, AT1 bonds are different from your usual bond instruments in that banks can skip interest payouts or reduce the bonds’ face value (the value of the bond at maturity).

    Moreover if the bank is under duress, its outstanding AT1 bonds could simply be cancelled. This is what happened with Yes Bank, whose AT1 bond dues totalling ₹8,415cr ($1.16bn) were infamously written off by the RBI as part of its bailout package.

    All these uncertainties make perpetual bonds relatively risky investments - which is why they offer relatively higher yields.

    FYI: In October 2020, probably on account of the Yes Bank fiasco, SEBI barred retail investors from buying AT1 bonds. Only qualified institutional investors can purchase these notes now.

     

    Coming Back to SEBI’s Circular...

    On March 10th, markets awoke to a rude shock. SEBI had announced that AT1 bonds’ maturity would be deemed to be 100 years and prices set accordingly from April 1st 2021.

    This made market participants nervous. The news was particularly unpleasant for mutual funds, which own more than a third of the outstanding ₹90,000cr ($12.42bn) in AT1 bonds issuances. (The regulator also asked fund houses to limit the ownership of these bonds at 10% of the assets in a scheme.)

     

    Why Did the Market Become Anxious?

    Remember the call option we talked about earlier? Mutual funds were so far accustomed to treating AT1 maturities as not more than 10 years. Effectively, the call option was treated as the maturity date.

    Treating them as 100-year bonds (especially with a barely seven-week notice) would make them way riskier since longer-term bonds = greater interest rate risk.

    And higher risk = higher yields = lower bond prices = lower Net Asset Values for mutual funds + greater redemption pressures.

    For banks, AT1 bonds have been a go-to choice for raising capital. Volatility and restrictions could have meant a crucial source of funds being stifled. Not good news for a sector ailing under bad loans and a resurgent pandemic. Particularly so for state-run banks, whose reliance on perpetual bonds is higher + some of whom are in line for privatisation.

    No wonder then that the Government rushed to intervene.

     

    A Brief Respite

    Under the relaxed timeline, the deemed residual maturity of AT1 bonds will be 10 years until March 31st 2022. It will be increased to 20 years from April 1st 2022 to September 30th 2022 and then 30 years for the subsequent six-month period until March 31st 2023.

    From April 1st 2023, the AT1 bonds’ maturity will be deemed as 100 years, as the original SEBI circular stipulated.

    So, SEBI’s announcement on Monday wasn’t necessarily a turnaround. The new rules still stand to be implemented - only at a later date. Mutual funds have only been given more time to adjust to the tighter norms. (The 10% ownership cap will still go into effect.)

    The extended time period could give fund managers and banks ample time to recalibrate their investments and bond issuances. Large-scale redemptions from mutual funds may not happen and banks may continue raising money unabated.

    But the larger concern with the 100-year maturity period remains. In the short-to-medium-term, AT1 bonds could lose favour with banks as reliable instruments to raise capital from. Investors were already wary about these bonds; the new rules may encourage them to exit such investments altogether. And fund houses, expecting this fallout, may look to offboard their AT1 exposure well before April 1st 2023.

    FIN.
     

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