Introduction
The SEBI's Circular SEBI/HO/IMD/PoD1/CIR/P/2024/106, dated August 5, 2024, introduces new valuation guidelines for Additional Tier 1 (AT-1) Bonds. These bonds, used by banks to bolster capital, are unsecured, perpetual, and non-convertible, offering higher yields without a put option. The updated guidelines mandate that mutual funds value AT-1 Bonds using the Yield to Call (YTC) method, reflecting their common market practice of trading near call dates. Endorsed by the NFRA under Ind AS 113, this method emphasizes market-based measurement. SEBI also maintains that perpetual bonds should be valued with a maturity of 100 years to account for liquidity risks. This circular, issued under the SEBI Act of 1992 and SEBI (Mutual Funds) Regulations of 1996, aims to protect investors and enhance market regulation.
Overview of AT-1 Bonds
AT-1 bonds, or Additional Tier 1 Bonds, are issued by banks to bolster their capital base, particularly during financial emergencies, without being subject to insolvency or distress measures. The issuance of AT-1 Bonds was first introduced after the 2008 financial crisis, which highlighted the need for banks to have stronger capital buffers.
Features of AT-1 Bonds
1. Nature of Bonds: AT-1 bonds are unsecured, perpetual, and non-convertible, designed to meet Basel-III capital requirements.
2. Acquisition Methods: These bonds can be acquired either through initial private placements by banks or secondary market purchases of existing bonds.
3. Interest Rates: They offer fixed or floating interest rates based on market benchmarks.
4. Liquidity: While AT-1 bonds are tradable on exchanges, they lack a put option, meaning investors cannot return them to the issuing bank for redemption.
5. Call Options: Banks may recall AT-1 bonds after a minimum of 5 years, but this is at the bank's discretion.
6. Interest Payments: Banks can defer or reduce interest payments or the bond’s face value under specific conditions.
7. Investment Base: These bonds are primarily held by large corporates, mutual funds, and high-net-worth individuals.
8. Loss Absorption: AT-1 bonds have a principal loss absorption feature that activates under certain conditions, either through conversion into common shares or a write-down mechanism, when CET falls below a specified threshold.
9. Regulation: These bonds are regulated by the Reserve Bank of India (RBI).
Valuation of Bonds
According to clauses 9.3.1.1 and 9.4.2 of the Master Circular SEBI/HO/IMD/IMD-PoD-1/P/CIR/2024/90, dated June 27, 2024, the valuation of bonds with multiple call options should be based on the lower value between the call option date and final maturity. For perpetual bonds, the maturity is assumed to be 100 years from issuance for valuation purposes.
Yield to Call (YTC) Definition
YTC measures the annualized return an investor would earn if the bond is purchased at its current market price and held until it is called by the issuer, often with an early repayment penalty.
Principles of Market-Based Measurement under Ind AS 113
1. Market-Based Measurement: Fair value is determined based on observable market transactions, not entity-specific conditions. The aim is to estimate the price of an orderly transaction at the measurement date.
2. Liability Transfer Assumptions: Fair value measurement assumes that a liability or equity instrument remains outstanding and is transferred to a market participant.
3. Observable Market Information: Even without direct market pricing, relevant observable market inputs should be used to estimate fair value.
4. Maximizing Observable Inputs: The goal is to use observable inputs as much as possible while minimizing unobservable inputs.
NFRA's Recommendation
The NFRA supports the use of YTC for valuing AT-1 bonds, aligning with market practices. However, the deemed maturity date for other purposes remains set at 100 years. The recommendation is specific to Ind AS 113 and does not extend to other valuation contexts.
Regulatory Authority
The circular is issued under Section 11(1) of the SEBI Act, 1992, and SEBI (Mutual Funds) Regulations, 1996, to protect investors and regulate the securities market.
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