Earlier this week, market regulator SEBI said that effective April 1, mutual fund schemes cannot have more than 10 percent of their assets under management in perpetual or Additional Tier-1 (AT1) bonds.

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SEBI has also capped the scheme level exposure to a single issuer at 5 percent and mandated that the maturity of all such bonds would be treated as 100 years. Those schemes which were holding AT-1 bonds in excess of 10 percent were permitted to 'grandfather' them or continue as is.

The SEBI rule has led to three questions:

1)- How will a 100-year bond be valued?

2)- How will schemes adjust 100-year maturity in their portfolios to satisfy the Macaulay Duration criteria set by SEBI?

3)- How will banks raise capital if mutual fund participation is limited?

Currently, there are Rs 90,000 crore of outstanding AT-1 bond issuances in the market, of which mutual funds have exposure to Rs 35,000 crore.

The flutter created by the SEBI circular was quickly addressed by the Finance Ministry on March 12. The finance ministry stepped in to request SEBI to withdraw revised valuation norms with respect to 100-year maturity. The reasons mentioned were high marked-to-market (MTM) losses, possible large swings in MF NAVs and disruption in the debt market due to forced selling by mutual funds. The finance ministry also noted that capital raising by PSU banks would be severely impacted, leading to an increased reliance by banks on the government. A finance ministry circular said that norms on reducing concentration risks in MFs may continue.

So, what's all the fuss about?

First things first.

What exactly are AT-1 bonds?

AT-1 bonds are high-yielding annual coupon-bearing perpetual bonds with no fixed maturity date. That's why they are popularly called perpetual bonds too because they don't have a fixed maturity.

Who issues these bonds and for what?

These are issued by banks to comply with Basel III norms. These norms took effect after the 2008 global financial crisis which led to the collapse of a few banks and pushed many others to the brink. To comply with the norms and reduce the risk of insolvency, banks need to keep a minimum capital and one of the ways to do that is by issuing AT-1 bonds.

And the high yield that banks offer is the reason for their popularity. Mutual funds tap into these bonds to be able to offer that little extra to their investors.

This sounds like good returns with minimum risk, doesn’t it?

Remember that old saying - no pain, no gain? This gain comes at the risk of some pretty strong terms and conditions.

For starters, the interest paid to AT1 bondholders for a particular year is at the discretion of the bank.

If a bank makes losses in a particular year, they need not pay the interest in that year. And this unpaid interest cannot be carried forward to the next year.

Does the issuing bank ever redeem these bonds?

AT-1 bonds are issued with call options - this means that each bond will pay interest up to its call date - which is the date on which the issuer, in this case, the bank can call back the bond and pay back the lender.

For example, a bank can issue a bond with a call date 3 years later... so, for these 3 years, the bank will keep servicing the interest, unless it makes a loss and on the pre-decided call date, they will redeem the bond. This call option is just that - an option. The bank may choose not to call that bond and reset the call option to a particular date in the future. This is what happened with Yes Bank - they decided not to call back their AT-1 bonds a few days prior to the call date. But in most cases, this call date is used and that is why mutual funds have been using this date as the maturity date and calculating the duration of their portfolios accordingly.

When does a bank redeem these bonds ahead of the call date?

If interest rates are falling, the issuing bank will want to redeem the existing bonds and issue fresh bonds at a lower rate of interest.

Also, there is no put option available -- this means that the bondholders cannot choose to redeem at will. They cannot ask the issuer to wrap up the bond early. They can choose to sell it in the secondary market but will suffer a loss of value most likely.

As well, if a bank goes into liquidation, then AT-1 bondholders do not get priority status for repayment. Technically, AT-1 bonds are considered subordinated unsecured bonds and are fourth in the repayment priority.

Here are some of the more significant risks

If the common equity Tier-1 of the bank drops below a specified level (6.125 percent as of March 2019), the AT-1 bonds can be written off or converted into common equity. As was in the Yes Bank case, the Reserve Bank can also step in and specify a 'Point Of Non-Viability' which would write off the claims of the bondholder. Again, a reminder of what happened in the Yes Bank case.

Why has SEBI clamped down on AT-1 bond investments by mutual funds?

Debt mutual funds have been subscribing to AT-1 bonds as an attractive and safe option (since the liquidation of a bank is considered a rare event). But experts say, this exposure should be seen as quasi-equity and that risks are not commensurate with the fixed returns offered, even though they may be higher than the market. Perhaps, this is what had prompted SEBI to issue stricter norms in the first place. SEBI had also earlier capped the non-institutional exposure to AT-1 bonds at a minimum of Rs 1 crore.

Even as the bondholders in the Yes Bank case (AT-1) and later the Lakshmi Vilas Bank case (AT-2)continue to be haunted by their losses, some conservatism on AT-1 bond holdings would hold the debt funds in good stead.

(Edited by : Anshul)

First Published:Mar 12, 2021 3:25 PM IST