SEBI revises valuation rule for AT-1 bonds: Here’s all you need to know

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Markets regulator Securities and Exchange Board of India (SEBI) has revised the valuation rule of perpetual bonds. In its statement, the regulator said the deemed residual maturity of Basel III additional tier-1 (AT-1) bonds will be 10 years until March 31, 2022.

The circular also mentioned that the maturity period of such bonds will be increased to 20 years effect 1st April 2022 and from October 1, 2022 will be further increased to 30 years. Effective April 2023, the residual maturity of AT-1 bonds will become 100 years from the date of issuance of the bond.

In addition, SEBI said that deemed residual maturity of Basel III Tier 2 bonds would be considered 10 years or contractual maturity, whichever is earlier, until March 2022. After that, it will be in accordance with the contractual maturity.

Further, if the issuer does not exercise the call option for any bond then the valuation will be done considering the maturity of 100 years from the date of issuance for AT-1 bonds and contractual maturity for tier-2 bonds, for all bonds of the issuer, SEBI said.

In addition, if the non-exercise of call option is due to the financial stress of the issuer or if there is any adverse news, the same need to be reflected in the valuation, it added.

The valuation norms were revised based on the representation made by mutual fund industry and request from finance ministry.

What are AT-1 bonds?

AT-1 bonds stand for additional tier-1 bonds. These are unsecured bonds that have perpetual tenor or have no fixed maturity date. These bonds have a call option, which can be used by the issuer to buy these bonds back from investors. AT-1 bonds are typically used by banks to bolster their core or tier-1 capital and are inferior to all other debt and only senior to common equity. This means if a bank goes into liquidation AT-1 bondholders stand last in the queue for recovery but before equity shareholders. Also, if a bank posts a loss these bondholders won’t get any interest payments.

Why are AT-1 bonds in news?

These bonds came into the limelight after the Reserve Bank of India (RBI) allowed a write-off of Rs 8,400 crore on AT-1 bonds issued by Yes Bank after it was rescued by State Bank of India (SBI) last year. 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.

To avoid wealth erosion for investors SEBI probably decided to change the rules pertaining to the valuation of AT-1 bonds. On March 10 SEBI issued a circular stating, “the maturity of all perpetual bonds should be treated as 100 years from the date of issuance for the purpose of valuation. The framework was to come into effect from April 1, 2021.”

Impact on mutual fund schemes due to this change

Prior to SEBI’s March 10 circular mutual fund use to treat AT-1 bonds maturity as the date of call option. This has been in practice for years in India and many developed markets also follow the same valuation parameter. Post SEBI’s March 10 notification these bonds were to be treated as ultra-long-term instruments effective April 1, 2021. This increases the risks for bondholders as they invested in the bonds call date as maturity, which in turn will lead to a decrease in the net asset value of MF schemes holding these bonds.

“NAV has already taken a hit for schemes holding such bonds since the first circular came out. The fall has been in the range of 1-1.1% of the portion holdings of such bond. So, if a scheme is holding 10% in AT-1 bonds the fall will be in the range of 12 basis points in a year’s time. If the scheme is holding 30% in AT-1 bonds the fall will be 36 basis points for the one-year call option whereas, for the longest duration period of four years, the fall be in the range of 1.2-1.3%. The churn has already happened since the time the first circular came out. Now fund houses would be looking to hold these bonds as they are issued by strong banks like SBI, HDFC Bank, Bank of Baroda and others. SBI being the largest issuer for such bonds. In case they will have to sell it will because of redemption pressure,” said Dwijendra Srivastava, CIO-Debt at Sundaram Mutual Fund.

Should investor panic or continue investing in schemes holding AT-1 bonds?

Given the back forth on the regulations front, you shouldn’t panic. Well, the most important thing to understand is that SEBI has given diktat to recognize the risk that these bonds hold. Commenting on the revised circular on AT-1 bonds Lakshmi Iyer, CIO (Debt) & Head Products at Kotak Mutual Fund said, “one needs to note that this is not a credit event, nor does it materially alter the liquidity profile of schemes which own such bonds. Hence investors may have witnessed volatility in the recent past, but various past experiences suggest that investors tend to benefit by ignoring near term volatility. It is hence very important to stay the intended investment tenor.”