The impact of valuation change in AT1 bonds

Last few weeks witnessed frenetic communication over AT1 bonds, occupying a lot of space and print in the financial news. The topic has come back into the general realm after the Securities Exchange Board of India (SEBI) wrote-off the entire value (Rs 8,415 crore) of the AT1 bonds as part of the rescue package for Yes bank. Last week a bench at Bombay HC admitted a petition of AT1 bondholders' plea for claims worth Rs 160Cr.

Additional tier -1 bonds, popularly known as AT1 bonds are issued by the banks to shore up their core capital base to meet Basel III norms. Basel III is a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk. This third instalment of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007-08. It's intended to strengthen the bank capital requirements by increasing bank liquidity and decreasing bank leverage.

Under the Basel III framework, bank's regulatory capital is divided into tier-1 and tier-2 capital. The tier-1 is further sub-divided into Common Equity (CET) and Additional Capital (AT1). The norms require banks to maintain a total capital ratio of 11.5 per cent of which 8 per cent in tier-1 capital i.e., own equity, reserves, etc. and tier-2 (supplementary reserves and hybrid instruments, etc.). AT1 bond forms part of the tier-1 capital and is a type of unsecured, perpetual bond that has no maturity while the issuing bank has the option to call back the bonder repay the principal after a specified time.

Though these instruments have a face value and fixed coupon, are not similar to your normal bonds due to the voluntary call option. This means, the issuing bank could use the call option to vest the bond if they deem no further capital requirement. This unfortunately is also considered as a possible fixed nature of the bond by some investors who looking for a better return (higher coupon) ended up investing in them. Also, the issuer could skip paying the interest partially or fully without creditors being able to question them as a default. As these bonds are issued primarily to shore up 'equity' capital of banks, the regulator allows banks to hold back coupon payouts if the bank makes losses or faces insufficient reserves.

Moreover, the banks could altogether write-down the principal and not just the interest payments, in case of bank's weak financials. The 'principal loss absorption' is a key term for all AT1 bonds, allows the issuing bank to simply write-off the face value (principal) either in full or partial if its CET ratio goes below 6.125 per cent. Another damning feature of these bonds are the Point-of-Non-Viability (PONV) where the RBI has right to direct a bank to write-off the entire value of its outstanding AT1 bonds if it feels that the bank requires a public sector capital infusion to remain a going concern. The Yes bank saga had highlighted this. Earlier in the month, Sebi has issued a circular stating that maturity of all perpetual bonds should be treated as 100 years from the date of issuance for the purpose of the valuation. It has also issued regulations that put a limit of 10 per cent for cumulative investments by MFs (mutual funds) in tier-1 and tier-2 bonds. In a response, the finance ministry has asked the market regulator to withdraw its directive to MF houses to treat AT1 bonds as having maturity of 100 years as it could disrupt the market and impact capital rising by banks.

The absence of any specified valuation norms, many MFs used to consider the call-option date on such bonds as the maturity date. According to an estimate of the outstanding AT1 bonds of Rs. 90K Cr, over Rs 35K Cr are held by MFs. The new directive had resulted in valuation concerns of these bonds with yields of perpetual bonds issued by SBI and BOB had gone up by as much as 90 basis points (bps) following Sebi's circular. Some banks have even deferred the issuance of fresh AT1 bonds to avoid paying higher yield.

However, last Monday, Sebi has ended the logjam by amending valuation rule of perpetual bonds. In a statement, Sebi said that the deemed residual maturity of Basel III AT1 bonds will be 10 years until March 22. It also mentioned that the period will be increased to 20 and 30 years over the subsequent six-month period. From April 23 onwards, the residual maturity of AT1 bonds will become 100 years from the date of issuance of the bond. This would kick into force from 1st April 21 and thanks to the gradual tinkering, the MFs wouldn't be taking too much disruption to accommodate the newer changes.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)