Relaxations in valuation norms for AT1 bonds

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Recently, Sebi has announced some relaxations in valuation norms for AT1 bonds.

It was done after the Finance Ministry asked Sebi to review restrictions on mutual fund investments in additional tier-1 (AT1) bonds.

Why did the Finance Ministry ask Sebi to review the original decision?

The Finance Ministry has sought withdrawal of valuation norms for AT1 bonds prescribed by Sebi for MF houses as it might lead to MFs making losses and exiting from these bonds, affecting capital raising plans of PSU banks.
The government doesn’t want the fund mobilisation of banks disrupted at a time two PSU banks are on the privatisation block.

What was the original Sebi directive?

On March 10, Sebi directed mutual funds to value these perpetual bonds as a 100-year instrument.
- This essentially means MFs will have to work on the assumption that these bonds would be redeemed in 100 years.
The regulator also asked MFs to limit ownership of the bonds at 10% of the assets of a scheme, as these could be riskier than other debt instruments.
- Sebi has possibly made this decision after the RBI allowed a write-off of Rs 8,400 crore on AT1 bonds issued by Yes Bank Ltd after it was rescued by the State Bank of India.

Relaxation provided by SEBI

AT1 bonds will continue to be treated as 100-year bonds and there will be unwinding of positions by mutual funds in a specific timeframe.
The deemed residual maturity of Basel III AT-1 bonds will be 10 years until March 31, 2022.
- It will be increased to 20 years from April 1, 2022, to September 2022, and 30 years for the subsequent six-month period.
- From April 2023, the residual maturity will become 100 years from the date of issuance of the bond.

Deemed residual maturity of Basel III tier-2 bonds will be considered 10 years or contractual maturity, whichever is earlier, until March 2022.
- Afterwards, it will be as per the contractual maturity.
Sebi has also asked the Association of Mutual Funds of India to issue detailed guidelines with respect to the valuation of bonds issued under the Basel III framework, which should be implemented by April 1.

Sebi has given a timeframe to unwind the AT1 bond investment positions of mutual funds.
It’s temporary relieas they don’t have to rush for redemptions and prevent losses.
However, the original position of Sebi that perpetual bonds will be treated as 100-year bonds remains; there’s no change in the 10% cap on ownership of bonds in a particular mutual fund scheme.
Sebi has stood its ground on its basic premise on perpetuity and limit on investments while allowing mutual funds to exit at specific intervals.
There won’t be panic redemptions, but banks are unlikely to be fully happy with the partial relief.

Impacts on

Mutual Funds

MFs have treated the date of the call option on AT1 bonds as the maturity date.
If these are treated as 100-year bonds, it raises the risk as they become ultra-long-term instruments.
This could also lead to volatility in the prices of these bonds.
As the risk increases, so does the yields on these bonds.
- Bond yields and bond prices move in opposite directions, higher yield will drive down the price, which in turn will lead to a decrease in the net asset value of MF schemes holding these bonds.
There would have been panic redemptions and losses for MFs.
Moreover, these bonds are not liquid and it would have been difficult for MFs to sell these to meet redemption pressure.
With Sebi relaxing norms, there will be orderly liquidation of AT1 bond holdings.

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 soaring bad assets.
A major chunk of AT1 bonds is bought by MFs.
For banks, the latest Sebi relaxation doesn’t give any major relief as they are likely to find it difficult to get investors for AT1 bonds.

What are AT1 bonds?

These are unsecured bonds that have perpetual tenure — or no maturity date.
They have a call option, which can be used by the banks to buy these bonds back from investors.
The interest rate on these bonds is higher than fixed deposit rates which make them an attractive investment option.
The holders of these bonds can get their investments back by selling them in the secondary debt market unless the issuer redeems them.
AT1 bonds are subordinate to all other debt and only senior to common equity.
Mutual funds 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.

What are Basel Norms?

Basel is a city in Switzerland.
It is the headquarters of the Bureau of International Settlement (BIS), which fosters cooperation among central banks with a common goal of financial stability and common standards of banking regulations.
Basel guidelines refer to broad supervisory standards formulated by this group of central banks called the Basel Committee on Banking Supervision (BCBS).
The set of the agreement by the BCBS mainly focuses on risks to banks and the financial system is called the Basel accord.
The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
India has accepted Basel accords for the banking system.
Basel III norms were a set of rules that banking regulators around the world came up with after the global financial crisis in 2008, to strengthen bank balance sheets.

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