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Explained: What are AT1 Bonds and how are they related to mutual funds?

Tulika Tandon

AT1 Bonds: Why in News?

Government has recently asked Securities and Exchange Board of India to withdraw/ revoke 100 year maturity rule on AT1 Bonds. 

What has happened?

The decision of SEBI to put restrictions on the mutual fund investments in additional tier 1 bonds or AT-1 Bonds. This would reduce the value of mutual funds and this has caused hoopla in the banking industry.

The Finance Ministry has therefore asked the regulator, SEBI to withdraw this change which may affect the fundraising plans of the banks. 

What are AT1 Bonds?

  1. AT1 bonds are unsecured bonds with perpetual tenure. These bonds thus do not have any maturity date. They have a call option and can be used by the banks to buy them back from various investors. These bonds are used by the banks so that they can bolster their core capital.
  2. AT1 bonds are subordinate to all other debt and only senior to common equity. These bonds give better returns than the rest of the bonds but have no maturity date like other bonds. 

Facts about AT1 Bonds

  1. AT1 bonds are designed to be part of permanent equity for banks
  2. The interest can be skipped if the banks’ capital ratio falls below 8%
  3. They need not mature within in 5 to 10 years
  4. They can write down your principal, temporarily or for good
  5. These bonds are completely unsuitable for regular income or capital safety goals

History of AT1 Bonds

The concept of additional Tier 1 bonds was publicised after some of the global banks went bust during the great financial crisis and Basel III norms were formulated. Basel III made a very clear rule for the banks to raise the amount of their own capital that is needed to carry in their balance sheets, before external deposits and loans are raised.

Indian banks as per these norms are directed to maintain a total capital ratio (CAR) of 11.5%, split into 8% in tier 1 capital (own equity, reserves etc) and tier 2 (supplementary reserves and hybrid instruments). 

The point to note here is that AT 1 bonds, also known as “unsecured subordinated perpetual non-convertible” bonds, make up part of a bank’s Tier 1 or permanent capital. Banks issue them to make sure they can meet Basel III norms on equity capital. 

What is the link of AT1 Bonds with Mutual Funds?

Mutual funds are the largest investors in AT1 bond generated capital that is perpetual debt instrtuments.At present they hold over INR 35000 crore of the outstanding additional issuance of tier 1 bond issuances of INR 90000 crore. 

SEBIs actions:

SEBI has directed the mutual funds to value the perpetual bonds as a 100 year instrument. This has been understood as the mutual funds to make assumptions that the bonds can be redeemed in 100 years. They would also limit the ownership of the bonds that are 10% of the assets of a scheme.

So until now the Mutual Funds had treated the date of the call option on AT1 bonds as maturity date. Now in case they are treated as 100 year binds, it raises these bonds as they become ultra long term.

This could also lead to volatility in the prices of the bonds because the risk increases the yields on these bonds rises. Higher the bond yield lower the price, lower the net asset value of the mutual fund scheme. So as the AT1 Bonds were the choice of capital instrument for banks, the restrictions on them would be causing trouble for the banks. 

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