In the additional tier-1 bonds drama, there is a need to find middle ground | Mint

In the additional tier-1 bonds drama, there is a need to find middle ground

Ultimately retail investors could be hit as net asset values may erode if SEBI’s rule is applied
Ultimately retail investors could be hit as net asset values may erode if SEBI’s rule is applied

Summary

What is needed is a middle ground where valuations can reflect risks, rather than err on extreme caution or exuberance

Additional tier-1 (AT-1) bonds have found themselves surrounded with drama yet again, this time on the issue of valuation. Introduced in 2007 in India as an extra route to raise capital for banks, these bonds came under fire just a year ago when the Reserve Bank of India ordered their value be written down to zero in Yes Bank’s rescue plan.

Since that jolt, investors have become jittery, issuances have dropped and trade in the secondary market has thinned out. Now the capital markets regulator wants mutual funds to honestly value these bonds for what they are: a perpetual instrument with no tenure. In the Securities and Exchange Board of India’s (Sebi) language, perpetuity is 100 years.

Uncalled problem
View Full Image
Uncalled problem

The regulator’s demand is not without merit. AT-1 bonds, or perps in market parlance, do not have a specific tenure, similar to equity, but they are debt instruments since they carry a yield. When these bonds were first introduced, the initial lukewarm response to them prompted issuing banks to sweeten the deal through call options.

A call option allows the issuer of a bond to call it back and prepay the investor before its maturity. Typically, banks offered call options at the end of the fifth or tenth year. Most issuing banks had in the past called back these bonds on the call option date.

“This regular practice had given investors the comfort that these bonds can be considered as a five-year bond or a 10-year bond. So they have been viewed and valued by investors so far and it has worked out fine," said Ajay Manglunia, head of institutional fixed income, JM Financial Ltd. To be sure, instances of banks not exercising the call option have been rare. The only examples are Yes Bank, Lakshmi Vilas Bank and Andhra Bank. All these lenders were highly stressed.

So, there is a need to shed the pretence that these bonds are short-term bonds. At the same time, pricing need not involve heartache to mutual funds.

At stake is a pile of 35,000 crore of these bonds in the hands of mutual funds. Ultimately, retail investors could be hit as net asset values may erode if Sebi’s rule is applied. “The mark-to-market hit would be significant and the short-term impact would unnecessarily drive away investors," said a debt fund manager, requesting anonymity.

Note that these bonds are hardly traded and pricing a 100-year bond would be a first for investors since there are no precedents. Ananth Narayan, a professor of finance at SPJIMR, said a more nuanced way is to incorporate the risk of the issuer not exercising the call option and the interest rate risk involved. “These bonds get traded in the market and that is the true value of the bond. But on days when trades do not happen, the bond can be valued by incorporating the rating, the probability of not being called by the issuer and the interest rate risk involved," said Narayan.

The government has asked Sebi to remove the valuation diktat. What is now needed is a middle ground where valuations can reflect the risks, rather than err on extreme caution or exuberance.

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
more

MINT SPECIALS

Switch to the Mint app for fast and personalized news - Get App