Since banks accept deposits from the public, it is of prime importance that bank’s regulation is safeguarded for the interests of depositors. In order to keep a check on the financial health of a bank, regulators have made it mandatory for banks to divide their capital into 2 tiers. Tier-1 capital consists of the bank’s share capital and disclosed reserves. Tier- 1 capital of a bank is considered to be of the highest quality capital of the bank as it is completely available to cover any losses incurred by the bank. The higher the Tier-1 capital of a bank, the higher is the safety of the bank. In order to make sure that banks Tier-1 Capital never dwindles, banks come up with several initiatives such as issuing Additional Tier -1 bonds (AT-1) to increase their Tier-1 capital.

Indian banks as per these norms are directed to maintain a total capital ratio (CAR) of 11.5%, split into 8% in tier 1 capital (own equity, reserves etc) and tier 2 (supplementary reserves and hybrid instruments).

What are AT1 Bonds?

State banks generally issue Additional Tier 1 bonds (AT-1) bonds to shore up their core or Tier-1 capital. Unlike traditional bonds, they have few key features which make them different. The first feature is that these bonds carry no maturity date and hence are also known as perpetual bonds. AT1 bonds carry a call option of 5 years and 10 years. Secondly, banks issuing AT-1 bonds can skip interest payments if the bank‘s capital falls below the regulatory requirement at the time when interest is due, this way the bank will not be at a risk of default. Third, if a bank is unsteady and needs rescuing, the RBI can anytime ask the bank to cancel its AT1 bonds without informing the investors.

These bonds offer a high interest rate but carry considerable risk and hence should only be opted by investors with high risk-appetite. AT-1 bonds are subordinate to all other debt and only senior to common equity. This means, these bond holders fall far behind in the pecking order in which investors are paid in case the bank becomes insolvent. Given the higher risk, the rating for these bonds maybe lower than Tier - II bonds of the same issuer.

Mutual fund connection with AT-1 bonds

Mutual funds (MFs) are among the largest investors in the perpetual debt instruments segment and hold over Rs. 35,000 crore of the outstanding AT1 bond issuances of Rs. 90,000 crore. MFs usually valued these AT1 bonds by considering their call option date as the maturity date

What’s the SEBI stand on AT-1 bonds valuation?

On March 22, SEBI said 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

SEBI has given a timeframe to unwind the AT1 bond investment positions of mutual funds. SEBI also asked MFs to limit exposure to AT-1 bonds at 10% of assets in a scheme.

How does it impact MFs?

Before the SEBI order, MFs treated AT1s call option date as maturity date, now with SEBI asking MFs to treat these bonds as 100 year bonds , these bonds become ultra-long term. Ultra-long term would lead to volatility in prices of these bonds, and higher volatility implies higher risk. Now with increase in risk, the yield of the bond also increases. Bond yield and bond prices are inversely related therefore higher yield will drive down the prices of these bonds and that will lead to a decrease in NAV (Net Asset Value) of MFs schemes which are holding these bonds.

What impact does it have on banks?

If there are restrictions on investment by mutual funds in such bonds, banks will find it tough to raise capital at a time when bad loans are increasing and banks are in need of funds. State banks have cumulatively raised around $ 2.3 billion in AT1 instruments in 2020-2021 and these banks consider issuing AT-1 bonds as an alternative to raising equity since both the routes bolster Tier-1 capital.

The Finance Ministry has asked to withdraw the valuation norms for AT1 bonds prescribed by the SEBI for mutual fund houses as it might lead to mutual funds making losses and exiting from these bonds which will affect capital raising plans of PSU banks.