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.
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.