- Ishaan Chopra
Valuing AT-1 Bonds: SEBI Calling Spade a Spade
- Ishaan Chopra†
Recently, the tussle between the Ministry of Finance, and Securities and Exchange Board of India (“SEBI”) made headlines. The controversy pertained to the latest SEBI Circular regarding pricing and of Additional Tier- I Bonds (“AT-I”) issued by Indian Banks. AT-1 bonds are infamous among investors due to the “principal write off” which happened during the Yes Bank saga in March 2021. It is interesting how the SEBI Circular came exactly a year after the Yes Bank restructuring. Yes Bank saga involved a complete write off of the AT-1 bonds, which wiped out invested savings of thousands of retail investors. In this blog post we will try to understand the fundamental features of AT-1 Bonds and the pricing conundrum which SEBI Circular has created. Author has discussed the impact this move can have on the capitalization exercise of public sector banks. Additionally, author has opined that this SEBI Circular is much needed a pro- retail investor move, which disincentives mutual funds from exposing unsophisticated investors to high-risk AT-1 bonds. However, author cautions regarding the retrospective application of the SEBI Circular and its alleged ultra vires nature. The blog also discusses the regulatory independence of SEBI and analyses whether the statutory scheme enables the central government to issue binding directions to SEBI.
The Immortal Bonds
AT-1 Bonds are a product of 2007 Financial Crisis, which made several “Too Big to Fail” banks its victim. Regulators across the world understood the systemic importance of financial institutions like banks and consequently, wanted to reduce the risk these institutions can take. The result of these concern were the Basel-III Norms, which are a set of capital adequacy and risk regulation requirements for banks. RBI mandated compliance with these norms in 2015 and as a result, the Indian banks and investors were introduced to the novel AT-I Bonds. These “bonds” form the part of equity capital of the banks and helps banks comply with the stringent capital adequacy norms. Bonds forming part of “equity capital is inherently oxymoronic. This is where the unique features of AT-1 Bonds factor in: They are not vanilla bonds, they are unsecured subordinate perpetual non-convertible bonds. Let’s break down the features of these instruments and understand the terms which are stipulated:
1. Perpetuity and No Guaranteed Coupon
As perpetual instruments, AT-1 bonds do not have a fixed maturity date. The monies perpetually remain with the bank and helps them buff up their equity figures on balance sheets. This is unlike non-convertible debentures or fixed deposits where the investors are aware of the maturity dates.
Interestingly, these instruments have an embedded call option. This Option allows the bank to redeem the bonds after a specific number of years. However, this call option is exercised at the discretion of the bank. This effectively means that banks can choose to never exercise this call option.
To add to the trouble of banks not redeeming the AT-1 bonds, these instruments do not come with a guaranteed coupon either. Banks have the comfort of skipping coupon payments in certain circumstances. The contract terms also allow banks to hold back coupon payouts if they make losses and have insufficient reserves to meet the payout. Common Equity Tier-I (CET-I) Ratio is an important indicator of the financial health of bank. Simply put, CET-1 is a measure of bank solvency that gauges a bank’s capital strength, by measuring its equity against total assets. If CET-1 falls below 8%, banks have the discretion to withhold the coupon payment, in part or fully.
2. Principal Write-Off
This is the feature which makes AT-1 bonds predominantly equity. The repayment of principal is not guaranteed and the AT-1 capital of the bank is fully loss absorbent in nature. In fact, if the CET-I ratio falls below the 6.125% mark, the bank is empowered to write off the AT-1 bonds, in part or fully. Such a treatment is similar to how the equity of an insolvent company is written off. Additionally, The Point of Non-Viability (“PONV”) Clause provides absolute power to RBI to order the bank to write off its AT-1 bonds if it is of the opinion that the viability of bank as a going concern is under threat. The AT-1 bonds prescribe 2% CET as a triggering point for RBI to write-off such capital. However, the terms of the bonds confer upon RBI an absolute right to order a write-off if it is of the opinion that bank is struggling to continue as a going concern. It is the PONV Clause which led to the write off of Yes Bank AT- I Bonds.
The Ministry of Finance was spurred into action lately due to the change in norms regarding the duration of these bonds. The circular provided that: “the maturity of all perpetual bonds shall be treated as 100 years from the date of issuance of the bond for the purpose of valuation….”
This left Mutual Fund (MF) industry perplexed. Several debt focused mutual funds have heavy exposures to AT-1 bonds because of the attractive yield offered by them. The change in valuation norms can wreak havoc in the mutual fund sector because of the heavy mark downs in the value of the AT-1 bonds. To understand the impact of this development, it is vital to understand how markets value bonds. Pricing is based on a fundamental concept of finance of time value of money, which tells us that a dollar today is more valuable than a dollar tomorrow. To value bonds, the market players generally use a discounted cash flow method, where future recurring coupon payments and principal pay-out is discounted back the present time to determine the present value of the bond. Discount rate employed is generally the return which an instrument of similar risk is providing.
In light of these basics, it is interesting to see the impact of the presumed 100 year maturity. The call option on these instruments is general after 3-5 years. Given the market practice, it is widely expected that banks will redeem their instruments at the earliest opportunity. A failure to exercise call option can raise doubts about the financial health of the bank and it makes it difficult for banks to raise funds in future using such instruments. Andhra Bank in fact announced plans to skip the call option on its AT1 bond after five years, but changed its mind after market backlash. Accordingly, these instruments are priced by the market assuming that they will be redeemed within the specified call period of 3 to 5 years.
Let’s assume that a MF is holding an AT-1 Bond, with face value Rs. 1 Lakh and coupon at 8%. For pricing, it is assumed that it will be redeemed in 3 years i.e 2024. However, if we factor in the presumed 100 year maturity regulation, things change drastically. The repayment of 1 Lakh is now presumed to be happening 100 years down the line and not in 2024. This is as good as never having your money back. As discussed above, a lakh in 2024 is exponentially more valuable than a lakhs received hundred years down the line. This will plummet the present value of AT-1 bonds which the MFs are holding in their portfolios and will lead to massive loss for several investors.
Arguments by Ministry of Finance
Finance ministry jumped in and protested against this regulation because they understand the importance of MFs in meeting the capitalization requirements of the banks. MFs appetite for AT-I bonds has been a huge cushion for central government, who anyway regularly capitalize the public sector banks. A major chunk of AT-1 bonds is bought by debt focussed MFs. State banks have cumulatively raised around $2.3 billion in AT1 instruments in 2020-21. The change in valuation norms will diminish mutual funds’ appetite for such instruments, thus hurting issuing banks and increasing the burden on the Government to infuse more equity into public sector banks. This is alarming at a time when public sector banks are expected to have large capital requirements to handle the soaring rates of non-performing assets due to the pandemic.
While the stance of the government does reflect a concern towards the balance sheets of the public sector banks, it does not take into consideration the widespread contagion which AT-1 bonds can lead to and have led to in past. Debt MFs have been misrepresenting these instruments as debt and exposing guileless retail investors to these quasi equity instruments in the name of fixed returns.
SEBI’s response and alleged retrospective application
SEBI has reacted to the concerns from the ministry of finance and has given some leeway to mutual funds. In the latest circular, it has notified that the deemed residual maturity of AT-1 bonds will be 10 years until March 31, 2022. It will be increased to 20 years from April 1, 2022 to September 2022, and 30 years for the subsequent six-month period. From April 2023, the residual maturity will become 100 years from the date of issuance of the bond.
Much to the chagrin of investor community, SEBI has given these valuation guidelines a retrospective application. Both the circulars issued in this regard use the terminology “all perpetual bonds” and do not differentiate between the perpetual bonds invested in prior to and post the coming into force of the new valuation guidelines. To impose such guidelines on historical holdings which were acquired before these valuation guidelines will cause heavy losses to several retail investors who are already invested in these instruments. An interesting question which arises is whether SEBI has the competence under the SEBI Act, 1992 (“Act”) to issue such a retrospective circular. It is a settled proposition of law, that alteration of substantive law is always presumed and treated as having only prospective implications, unless the legislative enactment itself, expressly or impliedly mandates it to be retrospective. Apex Court has clarified that the Act does not empower SEBI to enact retrospective legislations behind the shroud of investor protection under Section 11(1) of the Act. In light of this, it will be interesting to see whether any of the stake holder challenges the vires of this circular. However, currently, the Ministry of Finance and the industry players seem to have accepted these guidelines as they themselves acknowledge that commercial realities of AT-1 bonds have long been mischaracterized.
Questions concerning regulatory independence
SEBI is a creature of the Act. Established as an autonomous statutory regulator for securities market, independence of SEBI from control and influence of the central government remains its hallmark. In light of AT-1 valuation tussle between the Ministry of Finance and SEBI, we can appreciate that regulatory independence is an essential because measures for protecting the interests of investors can be inconsistent with the interests of central government. It is clear that the change in valuation norms will increase the fiscal burden on the central government to recapitalize ailing public sector banks. The ongoing pandemic has crippled the economic health of the country and government has been forced to increase public expenditure exponentially. Accordingly, in light of this background, it can be argued that such valuation guidelines will exacerbate the already deteriorating fiscal health of the country.
The essential question which arises in this scenario: Whether under any circumstance SEBI can be bound by the direction of central government. For the purposes of engaging with this question, it is assumed that the subject matter of the direction given by central government falls within the statutory jurisdiction of SEBI. Section 16 of the Act provides some meaningful insight into this question. Section 16 stipulates the following
“16. (1) Without prejudice to the foregoing provisions of this Act 111[or the Depositories Act, 1996], the Board shall, in exercise of its powers or the performance of its functions under this Act, be bound by such directions on questions of policy as the Central Government may give in writing to it from time to time .
Provided that the Board shall, as far as practicable, be given an opportunity to express its views before any direction is given under this sub-section.
(2) The decision of the Central Government whether a question is one of policy or not shall be final.”
Section 16(1) provides that the board of SEBI is bound by the directions of central government on “questions of policy”. Section 16(2) clarifies that a determination by the central government as to whether the direction concerns a question of policy is subject to judicial review. Interestingly, Section 16 directions have never been issued by central government since the Act came into force. However, Section 16 does vest central government with a wide power to issue binding directions concerning questions of policy to SEBI. Analogous provisions granting central government with power to issue directions are also found in other statutes like Life Insurance Corporation Act, Airport Authority Act and Telecom Regulatory Authority of India, Act. Case laws concerning such provisions convey that scope of the term “policy” remains nebulous and such ambiguity has equipped the central government to impose binding directions. The faceoff between the Department of Telecommunication and Telecom Regulatory Authority of India is one of the more publicised instances of encroachment by issuing directions. In the context of AT-1 valuation rules, central government can articulate a novel argument explaining how such valuation regulations can impose fiscal burden on the state tackling a pandemic. For now, SEBI has accommodated the stance of the government by issuing a revised circular. In future, it will be intriguing to see how SEBI tackles any arm twisting under Section 16 of the Act.
The rejigged circular is a temporary relief for debt MFs as they can now re-adjust portfolios, which are often loaded with such perpetual bonds offering higher coupons. However, the original position of SEBI that perpetual bonds will be treated as 100-year bonds remains. SEBI has maintained its stance on basic premise of perpetuity and has given time to MFs to adjust to the new norms. Such a response has mitigated the heavy mark to market losses which the debt MFs would have sustained had the 100 year valuation norm been kept in original form. This is a case of SEBI calling spade a spade. The new valuations norms reflect the pith and substance of AT-1 bonds and disincentives debt MFs from exposing their unit holders to extraordinary risks associated with these instruments. This is a pro-retail investor move and in line with the goal of SEBI to enhance transparency in capital markets.
† Ishaan Chopra is a law graduate from NLIU Bhopal, 2021 and is working as an associate at a law firm.