Writing down bonds

Fund managers should not have ignored AT-1 bond risks

Asset management companies holding additional tier-I (AT-1) bonds of YES Bank are reportedly negotiating a deal to avoid a 100 per cent haircut by converting their holding into equity. According to the Reserve Bank of India’s (RBI’s) draft reconstruction plan for YES Bank, the AT-1 capital instruments under the Basel III framework are to be fully written down. The asset managers first decided to approach the Bombay High Court but are now seeking to minimise the damage. Meanwhile, Larsen & Toubro, which has exposure to YES Bank’s AT-1 bonds, has approached the court.
 
The reason why the asset managers are now seeking to convert their bondholding into equity is understandable. They are unlikely to get any relief from a court of law and what the RBI has proposed in its draft reconstruction scheme is perfectly in line with rules. An instrument like AT-1 bonds was created to absorb losses. The implementation of Basel III capital regulations in India clearly states: “If the relevant authorities decide to reconstitute a bank … write-down of AT-1 instruments will be activated. Accordingly, the AT-1 instruments will be fully converted/written down permanently before amalgamation/reconstitution in accordance with these rules.” It further notes: “… Write-down of any common Equity Tier 1 capital shall not be required before a write-down of any AT-1 capital instrument.” It is hard to argue that professional asset managers were not aware of the risks. In fact, AT-1 bonds offer higher yields, which clearly reflects the associated risks. But the fund managers seem to have focused only on the upside in terms of higher returns and ignored the risks.

 
Further, it is being argued that writing down bonds will make it difficult for banks to raise capital. Yields on AT-1 bonds have gone up in recent days and IndusInd Bank had to shelve its bond issue. However, on the positive side, this will lead to better pricing of risk and attract investors with a comparatively high risk appetite. This will also attach more importance to bank balance sheets. If asset managers in mutual funds or pension funds want to take advantage of higher yields, they would do well to properly evaluate the associated risks and convey the findings to the end investor. Bondholders have invested nearly Rs 94,000 crore in AT-1 bonds issued by Indian banks, and in some of the mutual funds, the exposure levels are at 20-30 per cent of the assets of individual schemes. The Securities and Exchange Board of India should look into such excesses. On its part, the RBI should not change its stance, as it will not only create confusion but also raise questions about its ability to handle the situation. Changing the plan significantly could make things more difficult, both for the regulator and State Bank of India.

 

On a broader level, the YES Bank crisis could affect confidence in private-sector banks and increase the cost of capital. Since the bulk of the incremental credit in recent times originated in private-sector banks, slower expansion in their balance sheets could affect the flow of credit to the productive sectors of the economy. The damage can perhaps only be minimised by a swift resolution of the YES Bank crisis.