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Consider yourself to be someone who has a low-risk profile when it comes to investing, one who usually picks debt-linked mutual funds over equity-linked mutual funds. Your investment would steadily grow, at a fixed rate (given the stable nature of debt investments) and the graph of your NAV (Net Asset Value) would be an evenly sloped upward graph. But one fine day, you wake up to see a sharp drop on the graph, your NAV falls drastically and your debt investment is in red now. That is exactly what happened with certain debt mutual funds holders in March when RBI announced Yes Bank’s rescue plans. The government on March 13 notified the Yes Bank Limited Reconstruction Scheme, 2020, prepared by the Reserve Bank of India (RBI). Together with the implementation of the scheme, Yes Bank has indicated that it will be writing down permanently and in full certain instruments qualifying as Additional Tier 1 (AT1) capital issued by it under the Basel III framework. However, common equity remains on the bank’s books without any write-down.
Investors in some of the debt schemes of Nippon India Mutual Fund that held the risky AT1 (additional tier 1) bonds suffered losses ranging from 8% to 23% when the bonds were written down and NAVs fell. The mutual fund industry as a whole had an exposure of about ₹2,730 crores (as on 29 February) to Yes Bank debt, much of it to AT1 bonds, according to data from RupeeVest, an online mutual funds distributor.
(Credits: Vijay Bate//The Hindu)
Before we delve into what exactly happened, we need to understand what exactly are AT1 Bonds. AT1 Bond is a special category of debt, issued by the banks to shore up their capital in order to meet Basil III requirements. AT-1 bonds have several unusual features lurking in their fine print, which makes them very different from plain-vanilla bonds. One, these bonds are perpetual and carry no maturity date. Instead, they carry call options that allow banks to redeem them after five or 10 years. But banks are not obliged to use this call option and can opt to pay only interest on these bonds for eternity. Two, banks issuing AT-1 bonds can skip interest payouts for a particular year or even reduce the bonds’ face value without getting into hot water with their investors, provided their capital ratios fall below certain threshold levels. These thresholds are specified in their offer terms. Three, if the RBI feels that a bank is tottering on the brink and needs a rescue, it can simply ask the bank to cancel its outstanding AT-1 bonds without consulting its investors. This is what has happened to YES Bank’s AT-1 bond-holders who are said to have invested ₹10,800 crores.
How the Write Down Impacted Investors
The write-down of AT1 majorly affected 3 segments of investors: Mutual Funds, Insurance Products, and Pension Funds. How these 3 categories got affected by the write down can be understood by understanding how the 3 regulators treat AT1 bonds, where 3 Regulators are SEBI, IRDAI, and PFRDA.
For Mutual Funds, there is no regulatory cap or any other restriction on buying AT1 bonds other than the standard single issuer and group limits. SEBI limits exposure to a single issuer at 10% and to a single corporate group at 20% (which can be extended to 12 % and 25% respectively, with the approval of the board of trustees). However, these limits are imposed at the time of investment. If the exposure to risky AT1 bonds subsequently rises due to outflows from the fund, Sebi rules don’t provide much relief. As a result, several funds saw their exposure to AT1 bonds issued by Yes Bank move far above the 10% limit and lost large sums of money. Yes Bank wrote down its AT-1 bonds worth ₹8,415 crores in the March quarter, upsetting large creditors including Nippon Mutual Fund, Franklin Templeton India, Barclays, and Kotak Mutual Fund.
The insurance regulator, on the other hand, is a little more circumspect when it comes to investments by life insurers in AT1 bonds. IRDAI has classified them as part of the equity allocation and not debt allocation. Also, insurers can only invest in AT1 bonds of banks with at least an “AA" rating. Insurers can neither invest more than 10% in any such issue nor can they invest in banks that haven’t declared dividends in the last two years.
PFRDA allows the all-citizen model of the National Pension System (NPS) to invest in AT1 bonds only through Asset Class A (alternative assets), according to PFRDA Investment Guidelines framed in May 2017. While these assets cannot be more than 5% of an investor’s NPS corpus, a very small segment of NPS subscribers invest in Asset Class A. Exempted provident fund (PF) trusts—another category of pension funds that are offered as an alternative to the Employees’ Provident Fund Organization (EPFO) coverage—face heavy restrictions in terms of investments in AT1 bonds.
Effect of RBI’s Stand on the Future of AT1 Bond Market
The Reserve Bank of India's stance that Yes Bank’s Additional Tier 1 bonds and subsequent write-offs are investments gone bad may act as a deterrent for fund managers and investors from investing in new issuances, especially those of mid-sized lenders with weak capital buffers.
They fear that if a bank’s capital falls below regulatory levels, these bonds could be written-off putting their investment at risk. In the Yes bank episode, investors saw more than ₹8,000 crores of their investments written off even though the bank had the option of converting the amount in full or part into fresh equity.
The Reserve Bank of India (RBI) in an affidavit, in Madras high court earlier this month, had said these bonds carry higher interest rates in lieu of risks and that these can be written off. This comes at a time when at least four banks--Bank of Baroda, HDFC Bank, Canara Bank and State Bank of India--have announced that a part of their fresh fundraising would be through AT1 bonds. Bank of Baroda plans to raise ₹13,500 crores through these issuances and so far it has been able to raise ₹765 crores, according to a report by Bloomberg Quint.
What’s Next for AT1 Bond Investors?
To be fair, AT1 Bonds are complex financial instruments for investors. They have a fairly high debt component at higher rating levels and more equity-like characteristics at the lower end of the rating spectrum. The price of AT1 Bonds may have a non-linear relationship with the rating, which means a notch change in rating could spawn a bigger change in yield on AT1 Bonds compared with simpler instruments.
Investors should be aware of the risks inherent in AT1 Bonds (which are higher than in Basel III Tier 2 bonds) and price them accordingly. The difference in yield of Basel III AT1 bonds over Basel III Tier 2 bonds at the time of issuance was around 130 bps. Whether this premium sufficiently factors in the additional risks associated with Basel III AT1 Bonds is a moot point.
One Golden Rule going forward: Whenever a bond offers extra yield, look for the wolf in sheep’s clothing.
Dilip Mishra is a B.Com (Hons.) graduate from the University of Delhi and has previously worked with S&P Global Market Intelligence as a Data Researcher.