Mutual funds: Know the risks associated with AT1 bonds

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May 25, 2021 3:15 AM

Mutual funds are among the largest investors in the perpetual debt instruments segment and hold over `35,000 crore of the outstanding AT1 bond issuances of `90,000 crore

Still it is a good idea to check the exposure in AT1 bonds while you are investing in a mutual fund scheme.

The Securities and Exchange Board of India (Sebi) capped mutual fund investments in debt instruments, especially with reference to AT1 (Additional Tier-1) bonds. Accordingly, no mutual fund scheme will be allowed to invest more than 10% of its debt assets in such bonds and not more than 5% in the bonds of a single issuer. This decision sent shock waves across the equity and debt markets. Let us discuss in detail on what is an AT1 bond and why Sebi placed such restrictions from the investors’ perspective.

What is an AT1 Bond
A bond is nothing but an acknowledgement of debt by a borrower (bond issuer) wherein an investor lends a loan to a borrower for a fixed rate of interest with a predefined payment frequency and a maturity date on which the borrower should repay the principal. The characteristics such as fixed interest, defined frequency and payment at the end of the maturity date add certainty of cash flow to the investor. But, what makes AT1 bonds different is that they never mature which means that bond issuers will never ever pay back the principal.

So, these bonds are also called perpetual bonds. Though these bonds never mature they are issued with an embedded call option. This means that the borrower has the right (but not the obligation) to call back the bonds by paying the principal amount to the investors. So, AT1 bonds are unsecured bonds with perpetual tenure.

Associated risks
Generally, AT1 bonds are issued by banks to be part of a permanent equity capital base for them. The interest can be skipped if the banks’ capital ratio falls below a certain percentage or suffers a loss. These bonds are subordinate to all other debt and only senior to equity shares. These bonds give better returns than the rest of the bonds but have no maturity date like other bonds. These types of bonds are not suitable for regular income or capital safety goal oriented investors.

What are Sebi’s concerns
Mutual funds are among the largest investors in the perpetual debt instruments segment and hold over `35,000 crore of the outstanding AT1 bond issuances of `90,000 crore. Recently, Sebi asked mutual funds to value these perpetual bonds as a 100-year instrument which means fund houses value these bonds on the assumption they would be redeemed in 100 years. But, mutual funds so far valued the same by considering the call option date as its maturity date.

Further, the regulator also asked MFs to limit the ownership of the bonds at 10% of the assets of a scheme as Sebi considered these instruments as more riskier than other debt instruments. However, the finance ministry has asked Sebi to withdraw the circular as it could lead to disruption in the investments made by mutual funds especially in PSU banks. Accordingly, Sebi toned down its earlier order.

To conclude, as an investor even if your mutual fund scheme holds such bonds you need not worry. Because fund houses will gradually reduce their holding in such bonds and stay within the limits as prescribed by the regulator. Still it is a good idea to check the exposure in AT1 bonds while you are investing in a mutual fund scheme.

AT1 BONDS
AT1 bonds never mature which means that bond issuers will never ever pay back the principal.
AT1 bonds are issued by banks to be part of a permanent equity capital base for them. The interest can be skipped if the banks’ capital ratio falls below a certain percentage or suffers a loss.
AT1 bonds give better returns than the rest of the bonds but have no maturity date like other bonds. These types of bonds are not suitable for regular income or capital safety goal oriented investors.

 

The writer is a professor of finance & accounting, IIM Tiruchirappalli

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