A good glide path

AT1 bonds may lose sheen but Sebi takes the right call

The Securities and Exchange Board of India (Sebi) has taken a pragmatic decision to implement its proposed valuation method for perpetual bonds, or additional tier-1 (AT1) bonds in a phased manner. This comes after a request for review from the finance ministry and frantic lobbying from debt-mutual funds, which stood to lose heavily. The Sebi now proposes to reset valuation in three phases. Until March 31, 2022, residual AT1 maturity may be calculated at 10 years from the date of issue. Over the first half of 2022-23, residual maturity will be reset to 20 years and it will be extended to 30 years in the second half of 2022-23. From April 2023, the bonds will be deemed to have a maturity of 100 years. This glide path gives the market time to adjust and helps avoid a sudden crash in net asset values (NAVs).

However, it’s clear these instruments will be less attractive as the new method is applied. This poses problems for banks with weak balance-sheets, which were looking to shore up Tier-1 capital, without issuing fresh equity. An estimated Rs 85,000 crore to Rs 90,000 crore of these instruments are outstanding, mostly issued by public sector banks (PSBs). Around Rs 35,000 crore of these are held by debt-mutual funds. These instruments are perpetual and unsecured: The issuer is not under an obligation to ever redeem principal. Even though these offer higher yields, the issuer may also decide not to pay interest if it has suffered losses above a certain threshold. To add to the complexity, the issuer has recourse to recurring call options. Some bond holders were assuming the next call expiry date (which could be only one year away), was the date of redemption in valuing the bonds. Others were assuming an arbitrary five or ten-year period till redemption. This is highly unrealistic. Many of these issues are unlikely to be ever redeemed. The shorter the assumed tenure, the higher the valuation. Sebi has correctly flagged this overvaluation. It proposed the bonds be valued as possessing a 100-year tenure instead. However, there would be an instant, drastic fall in the NPV of the instruments if the new longer tenures were applied. This would have spooked investors who are already nervous about these instruments, after the Reserve Bank of India allowed Rs 8,400 crore of AT1 bonds issued by Yes Bank to be written off in 2020.

The proposed new method of a series of phased increases in the deemed tenures will allow funds to gradually write down the NPV. Thus, this is less likely to cause turmoil. But it also makes these instruments less attractive to the potential buyer, unless they offer much enhanced rates of return. This, in turn, means that banks would be less inclined to issue such bonds since they would raise less money and pay higher interest. The PSBs will have to find other ways to shore up Tier-1 capital if these bonds go out of fashion. The government may have to commit larger sums to recapitalisation — the 2021-22 Budget allocation of Rs 20,000 crore seems inadequate in any event. Lack of capital in PSBs will affect the flow of credit in the economy. The government would need to encourage PSBs to raise capital from the market and start the privatisation process.