The decision of the Securities and Exchange Board of India (SEBI) to slap restrictions on mutual fund (MF) investments in additional tier-1 (AT1) bonds has raised a storm in the MF and banking sectors.
The Finance Ministry has asked the regulator to withdraw the changes as it could lead to disruption in the investments of mutual funds and the fund-raising plans of banks.
Additional Tier-1 (AT1) Bonds?
- These are unsecured bonds that have perpetual tenure. In other words, the bonds have no maturity date.
- These have higher rates than tier II bonds.
- They have a call option, which can be used by the banks to buy these bonds back from investors.
- These bonds are typically used by banks to bolster their core or tier-1 capital.
- AT1 bonds are subordinate to all other debt and only senior to common equity.
- Mutual funds (MFs) are among the largest investors in perpetual debt instruments and hold over Rs 35,000 crore of the outstanding additional tier-I bond issuances of Rs 90,000 crore.
It has a two-fold risk:
- First, the issuing bank has the discretion to skip coupon payment. Under normal circumstances it can pay from profits or revenue reserves in case of losses for the period when the interest needs to be paid.
- Second, the bank has to maintain a common equity tier I ratio of 5.5%, failing which the bonds can get written down. In some cases there could be a clause to convert into equity as well.
Given these characteristics, AT1 bonds are also referred to as quasi-equity.
Differences between Common Equity (CET) and Additional Capital (AT1):
Equity and preference capital is classified as CET and perpetual bonds are classified as AT1. Together, CET and AT1 are called Common Equity.
By nature, CET is the equity capital of the bank, where returns are linked to the banks’ performance and therefore the performance of the share price.
However, AT1 bonds are in the nature of debt instruments, which carry a fixed coupon payable annually from past or present profits of the bank.
What action has been taken by the SEBI recently and why?
- In a recent circular, the SEBI told mutual funds to value these perpetual bonds as a 100-year instrument.
- This essentially means MFs have to make the assumption that these bonds would be redeemed in 100 years.
- The regulator also asked MFs to limit the ownership of the bonds to 10 per cent of the assets of a scheme.
- According to the Sebi, these instruments could be riskier than other debt instruments.
How MFs will be affected?
- Typically, MFs have treated the date of the call option on AT1 bonds as the maturity date.
- Now, if these bonds are treated as 100-year bonds, it raises the risk in these bonds as they become ultra long-term.
- This could also lead to volatility in the prices of these bonds as the risk increases the yields on these bonds rises.
- Bond yields and bond prices move in opposite directions and therefore, the higher yield will drive down the price of the bond, which in turn will lead to a decrease in the net asset value of MF schemes holding these bonds.
- Moreover, these bonds are not liquid and it will be difficult for MFs to sell these to meet redemption pressure.
What’s the impact on banks?
- AT1 bonds have emerged as the capital instrument of choice for state banks as they strive to shore up capital ratios.
- If there are restrictions on investments by mutual funds in such bonds, banks will find it tough to raise capital at a time when they need funds in the wake of the soaring bad assets.
- A major chunk of AT1 bonds is bought by mutual funds.
Why has the Finance Ministry asked SEBI to review the decision?
- The FM has sought withdrawal of valuation norms for AT1 bonds as it might lead to mutual funds making losses and exiting from these bonds, affecting capital raising plans of PSU banks.
- The government doesn’t want a disruption in the fund mobilization exercise of banks at a time when two PSU banks are on the privatization block.
- Banks are yet to receive the proposed capital injection in FY21 although they will need more capital to face the asset-quality challenges in the foreseeable future.
How RBI can take over the regulation of any bank?
There is an additional trigger in Indian regulations, called the ‘Point of Non-Viability Trigger’ (PONV).
- In a situation where a bank faces severe losses leading to erosion of regulatory capital, the RBI can decide if the bank has reached a situation wherein it is no longer viable.
- The RBI can then activate a PONV trigger and assume executive powers.
- By doing so, the RBI can do whatever is required to get the bank on track, including superseding the existing management, forcing the bank to raise additional capital and so on.
- However, activating PONV is followed by a write down of the AT1 bonds, as determined by the RBI.
Source: The Economic Times