What are AT1 Bonds?
Additional Tier 1 (AT1) bonds are a type of perpetual bonds. Banks use these bonds to increase their core equity base. Mutual funds are the major holders of perpetual debt instruments (AT1 Bonds), accounting for roughly INR 35,000 crore of the INR 90,000 crore in outstanding.
AT1 bonds never mature, implying that the bond issuers will never repay the principal. However, banks pay regular interest. But, if the bank’s capital ratio falls below a specific percentage or if the bank is making losses, the interest payments can be skipped.
AT1 bonds offer higher returns than ordinary bonds. However, they do not have a maturity date. Thus, Additional Tier 1 bond investments are not suitable for investors who are looking for regular income and risk-free or safe investments.
Features of AT1 Bonds
- No Maturity Date: AT1 bonds have no fixed maturity date, which means they can be perpetual. However, there are call options that allow the issuer to call back the bond after a certain period.
- Interest Rate: The interest rate on AT1 bonds is typically fixed but can be reset periodically. Furthermore, the interest rates are higher than other bonds.
- Subordinated Debt: AT1 bonds are subordinated debt, meaning they rank lower than other debts in case of default.
- Premature Recall: Banks can call back the bonds or repay after some time.
- Allotment Size: Minimum allotment and trading lot size must be INR 1 crore.
- Coupon Payments: The issuer has the right to skip coupon payments if it doesn’t meet certain regulatory capital requirements.
- Trade in the Secondary Market: AT1 bonds are listed on the stock exchange. Thus, the bondholder can sell their bonds in case they need to liquidate.
Risks of AT1 Bonds
- High Risk: AT1 bonds are considered high-risk investments due to their perpetual nature and subordinated status. In the event of a bank’s failure, investors may not receive any compensation.
- Coupon Payments: The issuer has the discretion to defer coupon payments, which can negatively impact investor returns.
- Early Recalls: Sometimes, banks may recall the bonds sooner than the expected date.
Basel III Norms for AT1 Bonds
The Base III regulations were introduced to oversee and manage the banking industry in the aftermath of the 2008 global financial crisis. These regulations mandate that banks maintain a certain level of capital as a contingency fund. The capital of the bank is split into two categories – Tier 1 and Tier 2. Tier 1 is further divided into Common Equity Tier 1 and Additional Tier 1 (AT1 bonds) capital. In the event that the Tier 1 capital falls below the prescribed limit, the bank will forfeit AT1 bonds, which will provide capital to the bank.
AT1 bonds are subject to Basel III capital regulations, which require banks to maintain a minimum level of capital. Under Basel III norms, AT1 bonds are considered “going-concern capital,” meaning they can be used to absorb losses in the event of a bank’s failure.
SEBI’s AT1 Bonds Regulations for Mutual Funds
As per SEBI’s regulations, mutual fund houses must value the perpetual AT1 bonds as 100-year instruments. Therefore, it implies that the fund must value these bonds on the basis that they will be redeemed in 100 years. However, mutual funds have previously valued the Additional Tier 1 bonds at the call option based on the option’s maturity date.
Furthermore, SEBI also instructed MFs to limit ownership of Additional Tier 1 bonds to 10% of the fund’s total assets. This is because SEBI feels AT1 bonds are riskier than other debt instruments. However, the finance ministry has asked SEBI to retract the circular since it could disrupt mutual fund investments, particularly in PSU banks.
According to the earlier circular, SEBI regulated changes to take place by April 2021. However, with the Finance Ministry’s intervention, SEBI changed the valuation rules. As per the latest circular, the residual maturity of Basel III AT1 will remain at 10 years until March 31, 2022. Furthermore, SEBI did not revoke its regulations, but it postponed its implementation for two years.
SEBI would increase the maturity period of AT1 bonds to 100 years from April 2023 due to the bond’s high-risk appetite. The bond’s expiration date will be calculated from the date of issuance.
Impact of Additional Tier 1 (AT1) Bonds
Before the regulations, mutual funds treated AT1 bond’s call provision date as its maturity date. However, new regulations suggest that the bond’s duration must be 100 years. This will make it an ultra-long term financial investment.
Furthermore, this has the potential to increase market volatility in bond valuations. Bond yields and bond prices are inversely proportional. To elaborate, due to the high-risk factor, the bond yield rises, and as a result, the NAV of the fund’s investing in the Additional Tier 1 bonds will fall.
The impact of SEBI’s regulations with respect to AT1 bonds will not significantly impact mutual funds investors. With relaxed norms, the mutual fund houses can liquidate their excess AT1 holdings in an orderly manner over some time.
Thus, if your mutual fund investments have exposure to AT1 bonds, you need not worry about these regulations. The fund will aim to gradually lower its holdings in such bonds to keep within the regulatory limits. However, while investing in a mutual fund scheme, it’s good to evaluate the Additional Tier 1 bond exposure.
Frequently Asked Questions
AT1 bonds are typically marketed to high-net-worth individuals, institutional investors, and mutual funds.
The yield on AT1 bonds can vary but is typically higher than traditional bonds due to their higher risk profile.
Yes, issuers can redeem AT1 bonds after a certain period, typically five years.
Yes, like any other bonds issued by a bank, AT1 bonds pay fixed interest.
The bank’s primary source of funding is Tier 1 capital, comprises of shareholders’ equity and retained earnings. Tier 2 capital comprises revaluation reserves, subordinated term debt, hybrid capital instruments, general loan-loss reserves, and undisclosed reserves.