Valuing AT1 bonds

A sudden change in the metrics will be disruptive

The concern over the market regulator’s guidelines on valuing perpetual bonds, such as additional tier-1 securities issued by banks, as 100-year bonds has its roots in the YES Bank crisis, and the Reserve Bank of India’s (RBI’s) action in that case. Investors lost heavily when the bank, prompted by the RBI, wrote off AT1 bonds worth Rs 8,400 crore, thereby putting them in a higher-risk category than even equities. The Securities and Exchange Board of India (Sebi) has rightly identified a serious problem with the valuation of these complex instruments and its suggestion will bring in more transparency to the process. The blame for the mess must go to rating agencies and mutual funds that tended to value perpetual bonds as five-year bonds. This was patently wrong practice because it gave the former higher value than they deserved. The valuation was based on the bonds’ call dates — the date at which the issuer could make an offer to call back the bonds and pay off the investors. It was not incumbent on the bank issuing them to do so, but these bonds were valued as if it were. In any case, perpetual bonds are supposed to be without a put option; so it is not clear on what basis rating agencies treated them as five-year bonds.

The malaise afflicting the banking sector led to these complex, high-risk instruments. Apart from YES Bank and IDBI Bank, many public sector banks (PSBs) have issued AT1 bonds, which are perpetual and unsecured, with no obligation to redeem. Indeed, the borrower is not obliged to pay the coupon if it is suffering losses above a set threshold. To compensate for the high risk, they pay higher coupons, which make them attractive to yield-chasing debt mutual funds. AT1 bonds also carry an embedded call option, which the issuer can exercise at specified times, thus complicating valuations further. Given the many PSB mergers, there is some nervousness among investors that the RBI may allow some of these to be written off.

About Rs 84,500 crore of AT1 bonds are outstanding, with PSBs issuing the bulk, and debt mutual funds holding over Rs 35,000 crore of such bonds. Sebi has also placed an exposure cap of 10 per cent of assets under management and 36 schemes with higher AT1 holdings must rebalance to comply with this cap. But liquidity is low, making market pricing impossible, and valuation is complex due to the call option. In their valuations, rating agencies and funds assume an AT1 bond will be redeemed when the next call is due, which is usually a five- or ten-year period. This is unrealistic: Many banks with weaker balance sheets will never exercise their calls to redeem. The net present value (NPV) of a bond with five years’ tenure is much higher than the NPV for a 100-year tenure. So this will mean a big write-down of net asset value, which might trigger panic redemptions and make future issues of AT1 bonds difficult and unattractive. That explains the finance ministry’s request to Sebi to withdraw the circular. The phased introduction of a new valuation method would be one way out of this dilemma after consultations between the central bank, Sebi, and the finance ministry.