Author: Mudit Gupta
Fifth- year Law student at University of Mumbai, Maharashtra
I. Introduction
After the Yes Bank case which took place in 2020, the trust of the investors was lost in the AT-1 bonds. This is evident from the fact that in the fiscal year 2020-21, banks were able to issue only INR 3000 crore worth of AT-1 bonds compared to INR 10,000 crore of the previous year and has not seen significant growth after that. The primary reason behind this is the stance of RBI and regulatory changes introduced afterwards, especially to the valuation methodology of the bonds by SEBI. To improve upon this situation, on August 05, 2024, the Securities Exchange Board of India ("SEBI") came up with a circular which provides for the valuation of the Additional Tier-1 ("AT-1") Bonds on Yield to Call ("YTC") Basis. This valuation methodology only applies to the AT-1 bonds and not to any other type of security. This valuation scheme has been introduced based on the changes proposed by the National Financial Reporting Authority ("NFRA") in its report to the Department of Economic Affairs, Ministry of Finance. It aims to provide flexibility to the issuers and the investors who invest in AT-1 bonds. This new valuation methodology will impact both parties in the spectrum as after quite some time this type of securities will be issued by the banks and will also attract investors to invest in them, despite the high risk involved.
This article has been prepared with the aim of critically examining the SEBI's new valuation scheme for AT-1 bonds. Firstly, it delves into the background that prompted the need for such a valuation scheme. After that, the article further explores the details of the new methodology and its impact on the stakeholders. In the end, the article concludes by summing up all the points discussed in the article.
II. Background
To understand the background of AT-1 bonds it is imperative to understand what they are. AT-1 bonds are perpetual debt instruments that provide capital to the banks and an interest-based return to the investor for an infinite period. However, they do not get their capital back as no maturity date is provided. The banks issue these bonds to manage their Capital Adequacy Requirements ("CAR") as per the Basel-III norms. These bonds are Contingent Convertible Bonds ("CoCos") which means that if the capital of the bank falls below a certain level, then, in that case, they can convert these bonds into equity which helps them reduce their debt efficiently. Investors get a higher return on their investment as compared to other instruments as they are to be for a very long period. These bonds have higher face value and most of the investors investing in these bonds are mutual funds or other institutional investors who have the bandwidth to invest in such high-value investment opportunities. All AT-1 bonds have a call option which allows banks to buy back these securities from the investors. Despite providing high returns to the investors these bonds also carry a very high risk because the issuer can skip interest payments if they are facing any financial distress. As per Basel III regulations, full coupon discretion is one of the main reasons they are riskier instruments which means that the interest payments can be skipped if the bank is in a situation where their capital ratios fall below a certain specified level. Another reason is that these instruments are designed to absorb losses at the point of non-viability and hence, these can be converted into equity of the bank faces a troublesome capital situation. Also, the instruments are only superior to equity and not to other debt instruments.
The investments in these bonds are at risk in a situation where the banking institution fails. One such situation was faced by the investors in the case of Axis Trustee Services Limited vs. Union of India & Ors (YES Bank case). In this case, the YES Bank faced a situation of collapse after fraud allegations, financial irregularities and non-performing assets. To counter such a situation RBI came in and various banks including SBI invested public money. In its reconstruction scheme, RBI also decided to write off the AT-1 bonds. This led to losses for the investors who invested their money in the AT-1 bonds. This included 1346 retail individual investors who had invested around INR 647 crore. They approached the Bombay High Court under the writ jurisdiction of the court which decided in favour of the investors and said that the write-off of the AT-1 bonds was not righteous in nature as it was not provided in the final approved reconstruction scheme by the government and the authorities acted out of their capacity. Also, the retail investors were misinformed by the officials of the YES bank as they were not told about the risks of the financial instrument. This ruling was appealed against by the defendants but the decision of the Bombay High Court was stayed by the Hon’ble Supreme Court of India. The final judgement on this case is still due.
III. Details of the Changes Proposed
After the YES bank case, the valuation norms for the AT-1 bonds were made stricter to avoid a similar situation. On March 10, 2021, the SEBI issued a circular which provided for a prudential investment limit for the mutual funds regarding AT-1 bonds and also changed the valuation scheme to align with the SEBI circular of September 18, 2000. Also, for the valuation of the bonds, the maturity period of all perpetual bonds was to be considered as 100 years from the date of issuance of the bond. This was not beneficial for the investors as this valuation methodology reduced the value of these bonds dramatically within a very short span of time. This led to various stakeholders approaching SEBI as the valuation scheme demoralized the AT-1 bond market in India. Therefore, on getting continuous requests from various stakeholders, SEBI modified the valuation scheme which made the situation much worse. SEBI issued a circular on March 22, 2024 which provided a timeline-based valuation strategy. For valuation, the maturity period was to be considered as follows:
i. 10 years up till March 31, 2022;
ii. 20 years between April 01, 2022, and September 30, 2022;
iii. 30 years between October 01, 2022, and March 31, 2023; and
iv. 100 years from April 01, 2023.
This valuation scheme led to a further decrease in the frequency of issuance of these perpetual bonds by the banking institutions as there was a lot of uncertainty and a lack of trust among the investors. Also, this valuation methodology was not in line with the market standards. As a consequence, significant concerns were raised by the RBI and the Indian Banks’ Association (IBA) regarding the valuation scheme proposed by the SEBI. Their opinion was based on the fact that the valuation scheme did not align with the domestic and international AT-1 bond valuation practices and hence, would hamper the growth of the market of such instruments in India.
After all this conundrum, earlier this year, the banks approached the NFRA to ease the valuation norms of the AT-1 bonds. The banks proposed to change the valuation methodology to either YTC basis or market-traded price. This proposal led to the formation and submission of the NFRA report to the Department of Economic Affairs after which the SEBI has notified the latest changes in the valuation methodology of the said perpetual bonds. The report also recommended revisiting the valuation methodology at least once in every 3 years so that the necessary changes could be made as per the market practices.
The new valuation scheme for the AT-I bonds for Banks is guided by the Fixed Income Money Market and Derivatives Association ("FIMMDA") which states that the pricing of AT-I would be the traded price and in the absence of any trades, the valuation is to be done on a YTC basis which is based on international practice for valuation of the AT-1 bonds. Further, the minimum ticket size for these bonds has been raised to Rs.1 crore to restrict large-scale participation of retail investors. However, the previously issued bonds are still operative in the market and are trading at a much lower value. This will leave the retail investors at risk for their past investments in AT-1 bonds as these were issued at a much lower face value and retail investors are neither fully aware of the risk involved in such investments nor they have the appetite for such high risk.
IV. Impact Evaluation of the New Valuation Scheme
It is anticipated that the new valuation scheme will create a positive impact on the Indian financial market. In this section, the author tries to assess this valuation scheme's impact on all the industry stakeholders.
The banking institutions which invite investments in these securities will be inviting this valuation scheme with open arms because this valuation scheme reduces the cost of capital for them because of their perpetual nature and loss-absorbing feature and also provides them with a lot of flexibility, especially regarding the conversion of these perpetual bonds into equity to reduce their debt efficiently.
The investors of this scheme, which are mostly going to be debt mutual funds or other institutional investors, will also be willing to invest their funds as this security gives them returns for a very long period which helps them manage their pool of investments effectively. Although this security is a high-risk security, the stance of the Indian judiciary in the Yes Bank case has assured them of their money being safe. Although the case is still pending in the Supreme Court, the stance of the Bombay High Court has inculcated a sense of trust among the investors. As the regulators have taken a stance to keep the minimum investment pool at Rs. 1 crore, individual retail investors will be restrained from investing in these securities which secures their money from such high-risk investment options. Despite this move, the presently traded AT-1 bonds are available at a much lower amount than 1 crore as they were issued at a much lower face value. Hence, it requires the attention of the regulators to take some effective steps in this regard in order to protect retail investors from the high associated risk.
V. Conclusion
The new valuation methodology conforms with the market standards at the domestic and international levels for fair market value. This is a very important step as it will serve the purpose of all the stakeholders in the market by providing low-cost capital to the banks and high-return investment options for the investors. The regulatory framework and the judicial stance taken in the YES bank case will further motivate both parties to issue and invest in this kind of security and will also bring transparency and trustworthiness to the system.
Note: This article has been reviewed by Mr. Vinod Kothari ( Managing Partner, Vinod Kothari and company ) at the Tier II Stage.