Dismal future of perpetual bonds: Mutual funds may suffer permanent loss of capital in Yes Bank’s AT1 bonds

This is for the first time in the history of the Indian banking sector that a bank’s tier 1 bonds is being written down at the ‘point of non-viability’

Kumar Shankar Roy Mar 7, 2020

amfi haircut rulesThe Yes Bank saga took a fresh turn when the Reserve Bank of India (RBI) on Friday placed in public domain a draft scheme of reconstruction for the troubled lender whose board was superseded and a withdrawal cap of Rs 50,000 was imposed for depositors less than 24 hours ago in an unprecedented 30-day moratorium. SBI, in an uncharacteristic white-knight style, has expressed its willingness to make investment in Yes Bank, the fourth largest private sector lender in India, and participate in a reconstruction scheme, which may also see other banks including some from the private sector come in.

The actual implementation of the reconstruction scheme will unfold in a few days, but one thing that has so far emerged is that investors holding Additional Tier-1 bonds (AT1 bonds) of Yes Bank have been cut a raw deal. Rating agency ICRA on March 6 has downgraded the ratings on Yes Bank’s Rs 10,800-crore AT1 bonds to ‘D’ (Default), after the bank did not pay the annual interest on the said bonds for the period ending March 5, 2020 pending RBI approval. Quite a few mutual fund-houses had debt exposure of Rs 2,800 crore in Yes Bank debt.

Also read: Mutual funds have debt exposure of Rs 2,800 cr in Yes Bank; Nippon India has the highest

Importantly, the AT1 bonds of Yes Bank are practically worthless now. There was always the risk of these bonds facing a terrible fate, but no one apparently thought this risk would actually arise. The net asset values of such exposed schemes already fell by up to 25% on March 5 due to valuation changes implemented by some fund-houses on their own. Let us take a closer look at this topic.

What are AT1 bonds

In an attempt to comply with Basel III norms to have higher tier I capital by financial year (FY) 2019, many Indian banks have raised capital through perpetual bonds, better known as AT1 bonds. These bonds offered higher rates than tier II bonds, because they carried more risk. These bonds have no maturity date and so they can continue to pay the coupon forever, an attractive opportunity for debt mutual funds. The issuing bank of course has the option to call back the bonds or repay the principal after a specified period of time.

In the case of Yes Bank, the lender issued Rs 10,800 crore worth such AT1 bonds. In a letter dated January 30, 2020, the bank had informed that it has decided to exercise call option for redemption of 10.25% Unsecured Non-Convertible BASEL II Tier I Subordinated Perpetual Bonds, subject to approval from RBI. The bank, however, did not exercise the call option. The bank also did not pay the annual interest on the said bonds for the period ending March 5, 2020 pending RBI approval.

As per the Information Memorandum (IM) of AT1 bonds, in case the authorities decide to reconstitute the bank or amalgamate the bank under Sec 45 of Banking Resolution act 1949, the bank will be deemed as non–viable or approaching non–viability and the trigger for write down/conversion of the additional tier 1 bonds will be activated.

AT1’s Catch-22 situation

The mere imposition of moratorium did not necessarily/automatically lead to erosion of value in investments in Additional Tier 1 bonds issued by the bank. Having said that, the seriousness of invocation under Sec 45 can’t be ignored. Read with the provisions in the Information Memorandum (IM), it exposes these bonds to the risk of a write-off/conversion, depending on the final scheme of reconstitution/restructuring as decided by the RBI.

“In light of all the above facts, the degree of uncertainty around the performance of these Additional Tier 1 bonds going forward will be hugely dependent both on the kind of decisions taken by the RBI and the Government as well as the timing of these decisions. As such, there is huge uncertainty w.r.t to realisable value of these bonds, pending clarity,” Nippon India MF said, which marked down perpetual bonds of Yes Bank to zero.

The valuation adjustment reflects the uncertainties around the realisable values, Nippon said, adding that such a move does not in any manner indicate any reduction or write off of amount repayable by Yes Bank or eventually realisable by the schemes holding these instruments. The AMC said it will continuously monitor the developments in Yes Bank, take appropriate steps in the best interest of its unitholders, and adjust valuations in line with incoming information and developments. There are also reports of the bondholders approaching courts on the complete write-down of the AT1 bonds.

Independent valuation agencies have revised valuation of AT1/AT-1 bonds and Basel II subordinated tier 1 perpetual bonds of Yes Bank. Franklin Templeton MF marked to market its exposure to Yes Bank bonds in line with guidance from valuation agencies i.e. at 47.5% of face-value. “AT-1 bonds contain write down/ conversion feature under certain circumstances…We shall take appropriate actions as clarity emerges on this matter,” Franklin Templeton MF said in an investor note.

Bye bye AT1 bond investments?

The announcement of a moratorium on Yes Bank and the release of a draft scheme of reconstruction strongly validates the inherent risk in Additional Tier-1 Bonds or Innovative Perpetual Debt Instruments (IPDI) which form part of the Tier-1 Capital of a bank, says Suman Chowdhury, President Ratings, Acuité Ratings & Research.

This is for the first time in the history of the Indian Banking sector that a bank’s T1 bonds is being written down at the ‘point of non-viability’ (PONV) i.e. the investors have to take a hit on both principal and the balance interest payments, Chowdhury noted.

“Clearly, the investors in such AT1 bonds, mainly comprising mutual funds and banks’ treasuries will need to take a significant hit due to this development. Acuité also believes that this will limit the market for AT1 bonds in India only to issuances by a few large public or A grade private sector banks and further, the pricing will see increased differential with that of Tier-2 bonds to reflect the differential risk,” Chowdhury argued.

Debt and hybrid mutual fund schemes who bought AT1 bonds went for higher risk, higher yield investment opportunity. In essence, AT1 bonds are quasi-equity style asset class, although, many would argue otherwise. As the Yes Bank chapter has shown, the risk of 100% capital loss exists in such bonds.

While these bonds are riskier, it is clear that a lot more work needs to be done to analyse the issuer risk. The fundamentals of a strong bank and a weak bank are different and so not each AT1 bond is same. But when a strong bank turns into a weak one, things can become murky.

RupeeIQ take

The AT1 bond investments in your mutual fund scheme is not something that you as an investor will likely know about it. It is difficult to separate bond exposure just by looking at the month-end portfolio/factsheets. This is one area the SEBI should look into so that each type of security held in a mutual fund scheme is properly written about so that investors with just one look can understand the risk & return in each security.

During the Essel/Zee group debt MF episode, the SEBI took strong steps that virtually ended the loan against shares (LAS) lending practice by mutual funds to company promoters. Let us see how the SEBI looks at AT1 bonds exposure of mutual funds.

Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. Kumar is a financial journalist, with a functional experience of 15 years. He tracks mutual funds, insurance, pension, PMS, fixed income/debt and alternative investments markets closely. He has worked for The Times of India, The Hindu Business Line, Deccan Chronicle Group, DNA, and Value Research, among others, across different cities in India. He is deeply interested in marrying data insights with actionable opinion. He can be contacted at kumarsroy@rupeeiq.com.

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