When the Reserve Bank of India (RBI) placed curbs on withdrawals from Yes Bank Ltd on 5 March, 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 net asset values (NAVs) fell. The mutual fund industry as a whole had an exposure of about 2,730 crore (as on 29 February) to Yes Bank debt, much of it to AT1 bonds, according to data from RupeeVest, an online mutual funds distributor. Insurance companies and pension funds were also exposed, but it appears the damage was largely contained. This is because as compared to Securities and Exchange Board of India (Sebi), the Pension Fund Regulatory and Development Authority (PFRDA) and the Insurance Regulatory and Development Authority of India (Irdai) take a much more conservative view of AT1 bonds. In all this, the retail investors who were directly sold AT1 bonds took the hardest hit as there was no regulatory cap to protect them. We explain how varying regulatory regimes have protected some investors, but not others, from this highly risky product.

What are AT1 Bonds?

AT1 are a special category of debt issued by banks. They are designed to absorb losses in case the bank’s equity capital dips below a certain threshold. Banks can stop paying interest on them and also write off their value. They do not have a fixed maturity date but a bank can repay them after specific tenures by exercising a call option on them. Under this call option, the bank has the right but not the obligation to pay back the principal amount on the specified dates. If the bank chooses to not repay the principal, it can carry on paying the interest on them in perpetuity.

The call option on AT1 bonds is, legally speaking, at the discretion of the bank, but until the recent troubles in Yes Bank, it was nearly always adhered to. Yes Bank refused to exercise the call options on its bonds in January and March 2020. This did not immediately create an event of default. However, after restrictions were placed on Yes Bank, a draft resolution by RBI envisaged a complete write-down of the value of AT1 bonds, which stood at around 10,000 croreU

Uneven impact
Uneven impact

Impact of write-down

On mutual funds: “There is no regulatory cap or any other restriction on buying AT1 bonds for mutual funds other than the standard single issuer and group limits," said Mahendra Kumar Jajoo, head, fixed income, Mirae Asset Mutual Fund. Jajoo had sounded the alarm about these bonds as early as May 2017. 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.

“This event has triggered a general realization that such a write-down clause actually exists. It has led to the repricing of AT1 bonds as a category. If AT1 holders are treated at a lower rung than equity, the category may lose its sheen," said Rahul Pal, head, fixed income, Mahindra Mutual Fund. A repricing implies that the bonds trade at a lower value (or equivalently, investors ask for higher yields as compensation). This can make raising money through AT1 bond issues significantly more expensive for banks.

The yield on State Bank of India’s own AT1 bonds jumped on 9 March, despite the bank’s government ownership and low-risk reputation. “Repricing will translate into a lower price for the bonds and a consequent fall in the fund’s NAV," said Pal, pointing out the risk of a further impact on NAVs of funds holding the bonds as markets determine the appropriate yield that reflects the risk in the bonds.

On insurance products: 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.

“The life insurance industry does not have a large exposure to AT1 bonds, so the impact is marginal. I don’t see this impacting the returns to policy holders or the bonus rates on policies," said A.K. Sridhar, director and chief investment officer, India First Life Insurance Co. Ltd. Life insurers do not take AT1 bonds as long-term instruments because there is always some kind of call option which may not work for investors; they prefer longer-dated government securities for this purpose, said Sridhar, adding that it was surprising to see open-ended debt funds having large exposures to AT1 bonds.

“An AT1 instrument can be converted into equity or completely extinguished when a regulator establishes a point of non-viability. Thus, there has always been an issue about its categorization as equity, debt, hybrid or alternative, as seen with its treatment by different regulators," said Arvind Chari, head, fixed income and alternatives, Quantum Advisors Pvt. Ltd.

On pension products: 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. According to Amit Gopal, India business leader, investments, Mercer, “For exempted PF trusts, there is a cap of 2% of the portfolio on investing in AT1 bonds. Also, such trusts can’t subscribe to more than 20% of the outstanding AT1 bonds of a bank," he said.

It is unclear how much EPFO has invested in AT1 bonds, but the relatively large size of its corpus limits the impact.

On direct investors: The worst hit were the retail investors, especially the senior citizens who were largely mis-sold these bonds by relationship managers of Yes Bank as better and safer products than FDs (read bit.ly/2TPCpUG). “What happened is a black swan event. Prior to this, no one expected a default in AT1 bonds," said Suresh Sadagopan, founder, Ladder 7 Financial Advisories.

“Sebi should put in some safeguards against them being sold to retail investors. One way could be asking investors to pass some kind of financial literacy test before buying complex products. Another could be a mandatory sign off from a registered investment adviser on such sales and taking them out of the hands of distributors," he added.

Mint’s take

Investors in debt mutual funds again bore the brunt of the lack of due diligence by fund managers. The event reinforces the need for investors to evaluate the extent of concentration in portfolios of securities, issuers and instruments.

Investors should take a call depending upon their comfort with the increased risk profile, the extent of exposure the fund has to AT1 bonds, the proportion of their individual portfolio that is invested in such funds, and the impact of costs and taxes on exit.

The need for stricter regulation of financial product distributors is stronger than ever before.

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