Valuation of Additional Tier 1 Bonds (AT-1 Bonds) SEBI circular dt 5th Aug 24

The SEBI Circular : SEBI/HO/IMD/PoD1/CIR/P/2024/106 dt 5th August 24 introduces key changes to the valuation of Additional Tier 1 (AT-1) Bonds, a financial instrument issued by banks to strengthen their capital base. These bonds are unsecured, perpetual, and non-convertible, offering higher interest rates but without a put option for investors. SEBI’s new guidelines, referencing its Master Circular from June 2024, mandate that mutual funds value AT-1 Bonds using the Yield to Call (YTC) approach. This method aligns with market practices where these bonds typically trade closer to their call dates rather than full maturity. The National Financial Reporting Authority (NFRA) supports this approach under Ind AS 113, which emphasizes market-based measurement. Despite this, SEBI retains the clause that treats the maturity of all perpetual bonds as 100 years for valuation purposes, ensuring that liquidity risks are adequately considered. This circular, issued under the authority of the SEBI Act of 1992 and SEBI (Mutual Funds) Regulations of 1996, aims to protect investors’ interests and enhance the regulation of the securities market.

What is AT-1 Bonds?

AT-1 bonds or the Additional Tier 1 Bonds are issued by banks in order to secure an SIB STUDENTS’ ECONOMIC FORUM | NOVEMBER 2020 external capital base to be used in times of a fnancial emergency without being subjected to insolvency and distress measures. The issuance of AT-1 Bonds was frst formulated after the 2008 fnancial crisis that saw the infamous fall of a banking behemoth ‘The Lehman Brothers’ in United States of America. The world economy witnessed an unavoidable slump due to the liquidity crunch that all the banks in the world faced at that time.

Features of AT1 Bonds

• AT-1 bonds are a type of unsecured, perpetual and non-convertible bonds that banks issue to shore up their core capital base to meet the Basel-III norms.
• There are two routes through which these bonds can be acquired:
• Initial private placement offers of AT-1 bonds by banks seeking to raise money.
• Secondary market buys of already-traded AT-1 bonds.
• The interest payable to the investors may be either at a fixed rate or at a floating rate referenced to a market determined rupee interest benchmark rate.
• AT-1 bonds are like any other bonds issued by banks and companies, but pay a slightly higher rate of interest compared to other bonds, which may turn out to be an alluring factor for the investors.
• These bonds are also listed and traded on the exchanges. So, if an AT-1 bondholder needs money, he can sell it in the secondary market.
• Investors cannot return these bonds to the issuing bank and get the money. i.e there is no put option available to its holders.
• Issuing banks have the option (subject to conditions stipulated by RBI being satisfied) to recall AT-1 bonds issued by them (termed call options that allow banks to redeem them after a minimum of 5 years). However, the banks are not compulsorily mandated to exercise such call option, it is the banks discretion whether to redeem the AT-1s or not.
• Banks issuing AT-1 bonds can skip interest payouts for a particular year or even reduce (subject to conditions) the bonds’ face value.
• The majority of investments since the inception of AT-1 bonds have been made by big corporates, mutual fund entities and high net worth individuals (HNIs) etc.
• These instruments have principal loss absorption feature at an objective pre-specifed trigger point through either (i) conversion into common shares or (ii) a write-down mechanism which allocates losses to these instruments. The loss absorption through conversion / write-down of AT 1 instruments is triggered when CET falls below a pre-determined threshold of Risk Weighted Assets (RWAs).
• AT-1 bonds are regulated by RBI.

Valuation of Bonds

• This has reference to clause 9.3.1.1 and clause 9.4.2 of the Master Circular No. SEBI/HO/IMD/IMD-PoD-1/P/CIR/2024/90 dated  June 27, 2024 for Mutual Funds (“Master Circular”), on valuation of bonds with multiple call options.

9.3.1.1 Securities with call option

1. The securities with call option shall be valued at the lower of the value as obtained by valuing the security to final maturity and valuing the security to call option.

2. In case there are multiple call options, the lowest value obtained by valuing to the various call dates and valuing to the maturity date is to be taken as the value of the instrument.

9.4.2 The maturity of all perpetual bonds shall be treated as 100 years from the date of issuance of the bond for the purpose of valuation.

• National Financial Reporting Authority (NFRA), in its report to Department of Economic Affairs, Ministry of Finance, has recommended that since the market practice for AT-1 bonds has been observed to trade at or quote prices closer to Yield to Call (YTC) basis, valuation of AT-1 Bonds on Yield to Call basis (adjusted with appropriate risk spreads) will be consistent with the principles of market-based measurement under Ind AS 113.

Definition of Yield To Call (YTC) :

The Yield To Call (YTC) of a bond measures the annualized return an investor receives if they buy the bond at its current market price and hold it until the company “calls” it by repaying the bond early, often with a penalty fee attached.

Principles of market-based measurement under Ind AS 113

1. Fair value is a market-based measurement, not an entity-specific measurement. For some assets and liabilities, observable market transactions or market information might be available. For other assets and liabilities, observable market transactions and market information might not be available. However, the objective of a fair value measurement in both cases is the same—to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability).

2. A fair value measurement assumes that a financial or non-financial liability or an entity’s own equity instrument (eg equity interests issued as consideration in a business combination) is transferred to a market participant at the measurement date. The transfer of a liability or an entity’s own equity instrument assumes the following:

(a) A liability would remain outstanding and the market participant transferee would be required to fulfil the obligation. The liability would not be settled with the counterparty or otherwise extinguished on the measurement date.

(b) An entity’s own equity instrument would remain outstanding and the market participant transferee would take on the rights and responsibilities associated with the instrument. The instrument would not be cancelled or otherwise extinguished on the measurement date.

3. Even when there is no observable market to provide pricing information about the transfer of a liability or an entity’s own equity instrument (eg because contractual or other legal restrictions prevent the transfer of such items), there might be an observable market for such items if they are held by other parties as assets (eg a corporate bond or a call option on an entity’s shares).

4. In all cases, an entity shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs to meet the objective of a fair value measurement, which is to estimate the price at which an orderly transaction to transfer the liability or equity instrument would take place between market participants at the measurement date under current market conditions.

• NFRA, in its report, has further stated that the above recommendation on YTC methodology is confined only to the interpretation of Ind AS 113 with reference to the valuation of AT-1 bonds and the issue of deemed maturity date for other purposes is outside NFRA’s remit : Section 132 of the Company Act – Constitution of National Financial Reporting Authority.
• In view of the above, in order to align the valuation methodology with the recommendation of NFRA, it has been decided that the valuation of AT-1 Bonds by Mutual Funds shall be based on Yield to Call.
• For all other purposes, since liquidity risk of perpetual bonds is required to be suitably captured, deemed maturity of all perpetual bonds shall continue to be in line with the clause 9.4.2 of the Master Circular.

Clause 9.4.2 The maturity of all perpetual bonds shall be treated as 100 years from the date of issuance of the bond for the purpose of valuation.

• This circular is issued in exercise of powers conferred under Section 11(1) of the Securities and Exchange Board of India Act, 1992, read with the provisions of Regulation 25 (19), 47 read with Regulation 77 of SEBI (Mutual Funds) Regulations, 1996, to protect the interests of investors in securities and to promote the development of, and to regulate the securities market.

Section 11 of Secutities and Exchage Board of India 1992- Function of Board

Provisions of Regulation 25 (19) Investment valuation norms of SEBI (Mutual Funds) Regulations, 1996.