Type: Prelims Only

The decision of the Securities and Exchange Board of India (SEBI) to slap restrictions on mutual fund (MF) investments in additional tier-1 (AT1) bonds has raised a storm in the MF and banking sectors.

What are AT1 Bonds?

• AT1 Bonds stand for additional tier-1 bonds. These are unsecured bonds that have perpetual tenure. In other words, the bonds have no maturity date.
• They have a call option, which can be used by the banks to buy these bonds back from investors.
• These bonds are typically used by banks to bolster their core or tier-1 capital.
• AT1 bonds are subordinate to all other debt and only senior to common equity.
• Mutual funds (MFs) are among the largest investors in perpetual debt instruments and hold over Rs 35,000 crore of the outstanding additional tier-I bond issuances of Rs 90,000 crore.

What action has been taken by the Sebi recently and why?

• In a recent circular, the Sebi told mutual funds to value these perpetual bonds as a 100-year instrument.
• This essentially means MFs have to make the assumption that these bonds would be redeemed in 100 years.
• The regulator also asked MFs to limit the ownership of the bonds to 10 per cent of the assets of a scheme.
• According to the Sebi, these instruments could be riskier than other debt instruments.

Try this PYQ:

Consider the following statements:

1. The Reserve Bank of India manages and services the Government of India Securities but not any State Government Securities.
2. Treasury bills are issued by the Government of India and there are no treasury bills issued by the State Governments.
3. Treasury bills offer are issued at a discount from the par value.

Which of the statements given above is/are correct?

(a) 1 and 2 only

(b) 3 Only

(c) 2 and 3 only

(d) 1, 2 and 3

How MFs will be affected?

• Typically, MFs have treated the date of the call option on AT1 bonds as the maturity date.
• Now, if these bonds are treated as 100-year bonds, it raises the risk in these bonds as they become ultra long-term.
• This could also lead to volatility in the prices of these bonds as the risk increases the yields on these bonds rises.
• Bond yields and bond prices move in opposite directions and therefore, the higher yield will drive down the price of the bond, which in turn will lead to a decrease in the net asset value of MF schemes holding these bonds.
• Moreover, these bonds are not liquid and it will be difficult for MFs to sell these to meet redemption pressure.

What’s the impact on banks?

• AT1 bonds have emerged as the capital instrument of choice for state banks as they strive to shore up capital ratios.
• If there are restrictions on investments by mutual funds in such bonds, banks will find it tough to raise capital at a time when they need funds in the wake of the soaring bad assets.
• A major chunk of AT1 bonds is bought by mutual funds.

Why has the Finance Ministry asked Sebi to review the decision?

• The FM has sought withdrawal of valuation norms for AT1 bonds as it might lead to mutual funds making losses and exiting from these bonds, affecting capital raising plans of PSU banks.
• The government doesn’t want a disruption in the fund mobilization exercise of banks at a time when two PSU banks are on the privatization block.
• Banks are yet to receive the proposed capital injection in FY21 although they will need more capital to face the asset-quality challenges in the foreseeable future.
• Fitch’s own estimate pegs the sector’s capital requirement between $15 billion-58 billion under various stress scenarios for the next two years, of which state banks account for the bulk.