The market for AT1 bonds, or additional tier 1 bonds, took a hit after the Rs 8,415 crore AT1 bond write-off by Yes Bank as part of the State Bank of India-led bailout in March 2020.
Investors turned wary. They began to look at these instruments with caution since then. A year later, the Securities and Exchange Board of India (Sebi) circular on AT1 bonds seems to have brought more bad news to AT1 bonds market, particularly for banks looking to tap these instruments to raise capital.
The uncertainty surrounding the Sebi circular could make it tough for smaller and weaker banks, mainly state-run banks, to raise capital, said experts. That's no good news for the sector.
To begin with, what are AT1 bonds? AT1 securities are a type of contingent convertible bonds designed after the financial crisis to try to ensure that investors would be on the hook if a bank runs into financial stress. Banks pitch these to retail investors as an attractive return option, often higher than what a traditional fixed deposit would offer.
In the case of Yes Bank, the bank executives allegedly engaged in misselling these bonds to retail investors pitching AT1 bonds as 'Super FDs'. Those investors are now locked in a legal battle with the bank and the regulator to get their money back.
Let's look at the present scenario.
What did the Sebi rules on March 10 say? Effective April 1, Sebi asked issuers to treat AT1 bonds as having 100-year maturity. Besides, it also capped the mutual fund exposure to a single issuer to 5 percent with respect to fresh issuances and said at the scheme level, no fund shall hold more than 10 percent of its NAV of the debt portfolio in such instruments.
What are the concerns here? The stipulation of 100-year maturity will lead to a re-rating of this market, bankers fear. "Already, these bonds were seen with less interest by the investors post the Yes Bank episode. Now there seem to be more troubles," said a treasury official with one of the private banks.
The longer the tenure, the higher the interest rate risk it carries. There is a fear that the Sebi rules could prompt existing investors to sell these bonds resulting in massive withdrawals on the part of retail investors.
“The AT1 bond circular from Sebi will mean more uncertainty for banks, especially smaller and weaker banks looking to raise capital issuing perpetual bonds. We need to see how the scenario evolves from this point,” said Jyoti Roy, banking analyst at Mumbai-based Angel Broking.
What is the exposure of investors to AT1 bonds? According to the Ministry of Finance, the exposure of mutual funds to AT1 bonds is around Rs 35,000 crore. The overall market is around Rs 90,000 crore. Banks have significant exposure to these instruments.
According to a Business Standard report, SBI alone has over Rs 11,000 crore worth call options due in FY22. Public and private sector banks have issued AT1 bonds worth Rs 1.02 lakh crore as of March 2021 and call option is due for Rs 31,290 crore in the next financial year, the BS report said.
The Sebi circular drew the ire of the Finance Ministry. The North Block wrote to the market regulator seeking to review the AT1 bonds circular citing the potential impact it could have on the market, especially banks. The Finance Ministry has raised a few key points:
One, with the new limits in place, the incremental ability of MFs to buy bank bonds will be constrained. This will result in an increase in coupon rates.
Two, with the tenure fixed at 100 years, and with no benchmark to mark these bonds against, the MTM (mark to market) losses on these instruments will be high and the abrupt drop in valuations will lead to large NAV swings as MFs will rush to sell these bonds fearing large redemptions.
Third, panic redemptions by MFs will lead to an impact on the corporate bond market and hence will lead to higher borrowing costs for corporations.
Fourth, capital raising by banks will get adversely impacted due to lower investor appetite.
Citing the above reasons, the Finmin has asked Sebi to review the circular on AT1 bonds. Will Sebi listen to the government’s request? Sebi, according to a report in Business Line, has defended its decision saying the circular will not have any immediate impact on MFs as their exposure is below the limits prescribed.
“Many PSU banks raise money through AT1 bonds,” said Sanjay Agarwal, Head of BFSI and NBFC at CARE Ratings. “It is too early to say how the scenario will evolve post the Sebi circular,” said Agarwal.
Despite the assurance of Sebi, MFs may turn extra cautious on AT1 bonds and this could mean some impact on the future AT1 bond issuances. Investors will now increasingly look at these instruments with high caution. If banks fail to tap this route for capital, at least with respect to the PSU banks, the additional capital burden will fall on the government.
Whichever way one looks at it, this will be a double whammy for capital-starved PSU banks and their majority owner--the government.