SEBI versus Mutual Funds on ATI Bonds

Recently the decision taken by SEBI with respect to AT1 bonds has raised concern by various bodies. The Finance Ministry itself has asked the regulator to withdraw the changes. The SEBI might have taken this decision following the RBI’s move to a write off of Rs.8400 crore on AT1 bonds issued by Yes Bank Ltd.

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AT1 Bonds: AT1 Bonds are additional tier-1 bonds. These bonds do not have any maturity date. They are senior to common equity and are subordinate to all other debts.The banks can buy back these bonds from investors by using the call option. The bank uses these bonds to cushion against their tier-1 capital. 

SEBI’s decision that raised the issue: AT1 Bonds are unsecured bonds. They comprise a major part of the outstanding additional tier-1 bonds. Via a recent circular SEBI has directed mutual funds to value tier-1 and tier-2 bonds as a 100-year instrument. Thus, they now have a maturity date and shall be redeemed by MFs in 100 years. MFs are told to limit their ownership of the bonds to a maximum of 5% in such securities issued by a single issuer and 10% in all such schemes put together.

The ruling will become effective from April 1. It was issued on March 11 and the Association of Mutual Funds of India agreed with the same via a press release. SEBI believes that these instruments being risky, the NAV of debt funds investing in them must reflect the risk levels that they carry. Staying of the ruling might result in debt funds hitting on their NAVs.

Banks and NBFCs can skip paying coupons in AT1 bonds, if they do not generate profits in a particular year. AT1 bonds come last in the queue while repaying creditors. T2 bonds can not skip payments. Tier-2 bonds stand before AT1 boldholders and equity shareholders.

As AT1 bonds are not liquid, MFs will find it difficult to sell them to meet redemption pressure. This could lead to a panic on the part of the mutual fund houses as they might resort to selling the bonds in the secondary market.

Additionally, since the MFs function taking the date of call option as maturity date on AT1 bonds, when a 100 year time span is attached to them, they will become risky as the term shall be too long. On account of a rise in risk, the yield will increase. But when yields increase, bond prices go down. And resultantly the net asset value of the schemes holding these bonds will decrease due to the lower price of the bonds.

How do the banks get affected?

State banks use the AT1 bonds as the capital instrument to support capital ratios. By levying restrictions on investments by MFs in such bonds, PSU banks will find it difficult to raise capital when they need funds on account of the soaring assets.MFs hold a major part of AT1 bonds.As an alternative to equity these bonds are highly popular among state banks and still account for a relatively small proportion, around one percent of risk-weighted assets,of the capital structure. These bonds give coupons which are 200 basis points higher than any other instruments issued by banks.

The valuation norms for AT1 bonds as prescribed by the SEBI for mutual fund houses might have an adverse effect driving them into losses and also exiting from these bonds. However, according to experts, large banks like SBI,ICICI and Canara Bank cannot be expected to dishonour their commitments. The schemes that can take credit risk should be allowed but others should be kept out of AT1 and T2 bonds. These bonds are semi equity kind and if repayment of principal and interest are put into danger, they should not be included in a debt fund.

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Krishna Rath is a SEBI Registered Investment Adviser, and since 2015 has been educating netizens on investments and insurance. Krishna is a fee only SEBI RIA and is Odisha's first SEBI RIA. With background in IT, Krishna is changing the advisory space with new innovations in AdvisoryTech.

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