The government, financial market regulators, banks (which issue such bonds), and asset managers (which invest in them) have discussed the matter in the weeks before the Diwali holiday. Banks and mutual funds chiefs have had meetings with the Securities & Exchange Board of India (Sebi) which formulates the valuation rules. A few senior CEOs of asset management companies have separately put across their point to officials of the finance ministry.Though AT1 bonds typically have a call option that lets the issuing bank redeem the papers at the end of five years or later, Sebi’s new valuation regulation require investing funds to treat the securities as papers with 100-year maturity. This, banks believe, have lowered the appetite for AT1 bonds.
BANKs Vs MFs
However, ‘what ails the AT1 bond market‘ has emerged as a contentious subject with banks and fund houses differing in views. The banking industry firmly believes that a change in the valuation technique – by lowering the bond tenor from 100 years to the year of the call option (as was the practice earlier) – would improve AT1 bond valuation in investors’ books and rekindle institutional demand. But fund managers, having distanced themselves from AT1 bonds, argue that investor interest would not be adequately restored as long as troubled banks can unilaterally write down the bonds without touching their equity.
“A back of the envelope calculation shows that banks will need over ₹1 to 1.25 lakh crore over the next two years to take care of growth and allocate money against asset risks. Very few banks can sell equity at premium and there would not be takers for AT1 bonds unless issued by a few top-notch banks. How would other banks raise capital? So, there is a growing feeling that a solution must be found for AT1 bonds,” said a senior fund manager.
The mutual fund heads have told the government that so long as AT1 bonds are treated worse than equities – or, considered riskier than equities in the financial hierarchy – funds would either stay away from AT1 bonds or invest in AT1 bonds of only a handful of top banks.
Though described as ‘bonds’, international regulations allow a bank to raise its core capital by issuing AT1 securities which can absorb losses when the lender runs into trouble. A bank in deep stress can write down or convert the outstanding high-return, high-risk AT1 bonds into equity to stay afloat.
A fierce tussle broke out between bondholders and Yes Bank in March 2020 when the latter wrote down ₹8,425 crore AT1 bonds but spared equity shareholders to save itself. Bond investors questioned the move as writing down bonds instead of equity, which is considered to be a riskier asset, was against the basic tenets of finance. Bondholders felt short-changed when RBI backed Yes Bank to showcase it as a turnaround example.
After the Bombay High Court set aside the write-down by Yes Bank, the bank and RBI moved the Supreme Court. The matter is currently pending before the apex court.
“We told the ministry that RBI should withdraw the SC case and accept the Mumbai High Court ruling. A change in valuation methodology is secondary. I agree treating AT1 papers at 100-year maturity have made valuations volatile. But Sebi changed the rule to 100 years only after the Yes Bank’s write-down decision,” said a fund house CEO.
“What RBI did may be legal but it is against all conventions of finance,” he said.
Traditionally, the call year was taken to assume the bond tenor for valuing AT1 papers. After the Yes Bank fiasco, investors began to fear that banks may not only abstain from exercising the call but even write-down such securities. What followed was Sebi’s direction in March 2021 to treat the perpetual paper as a security with 100-year maturity for valuation purposes. However, backing the need to change the valuation method, a senior banker said. “Yes Bank was a one-off case. Mutual funds and insurers (which follow the same valuation technique) must realise this. Interest in AT1 bonds suffered particularly after SEBI’s new direction on valuation. We feel the regulation should be relaxed and made at par with international valuation rules,” said a senior banking industry official.
As things stand, in the tangled mess of AT1 bonds, banks (the issuers regulated by RBI) put the blame on SEBI for the valuation rule while mutual funds (the investors regulated by SEBI) blame RBI for derailing the market. But authorities as well as all stakeholders want a way out for banks in need of capital to freely tap the AT1 bond market.