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The Perpetuity Mirage; Case Study on AT-1 Bonds

The authors are Shantanu Dhingra and Shiv Sankar, third year students at National Law University Odisha.


Introduction


Perpetual bonds, a hybrid financial instrument that combines elements of both debt and equity, have gained popularity in India in recent years. However, the emergence of Additional Tier-1 (AT-1) bonds has sparked a series of concerns and challenges due to their complex nature. This article explores the regulatory inconsistencies surrounding AT-1 bonds make them risky instruments. The lack of protection for bondholders' interests and difficulties in assessing their value and risk have garnered attention and need to be addressed through potential reforms. This article will provide an analysis of the challenges posed by AT-1 bonds, the regulatory landscape governing these instruments, and the potential impact of the proposed reforms.


Rights of AT-1 Bond Holders


The legal and regulatory framework governing AT-1 bonds in India is primarily aimed at ensuring the compliance of banks and NBFCs with CAR (Capital Adequacy Ratio) requirements set by the RBI. However, the nature of these instruments, as a hybrid between debt and equity, raises concerns about the lack of protection for bondholders' interests.


Under the Companies Act, 2013, in the case of the winding up of a company, the payment of debts and other liabilities are prioritized in a specific order. As per the Act, secured creditors, such as banks, have the first right to their outstanding dues, followed by unsecured creditors, such as bondholders, and finally equity shareholders. AT-1 bondholders are considered unsecured creditors, which means that they rank inferior to any other form of debt and are only superior to equity shareholders. In the event of the winding up of a company, bondholders are not entitled to the right to recoup their principal.


The Securities and Exchange Board of India (SEBI) has also issued guidelines for the issuance of AT-1 bonds, which require issuers to disclose the risks associated with these instruments in their offer documents. However, these disclosures may not always be sufficient to protect bondholders' interests, as mis-selling of these bonds to retail investors has been reported in the past.


The RBI mandates that NBFCs-ND-S (Non-Banking Financial Company - Non-Deposit taking) must issue AT-1 bonds as plain vanilla instruments, which means that they cannot include any embedded options or features that may compromise the bondholders' interests. However, NBFCs are allowed to exercise a call option after a minimum period of ten years from the date of issue, subject to prior approval from the RBI, and after considering the company's CRAR position.


The Step-Up option given to NBFCs by the RBI allows them to increase the interest on the bond once in its lifetime, after a period of ten years of issuing. However, this provision may be detrimental to bondholders as the perpetual nature of the bond may not keep up with inflation, and the inability to increase interest could impact the performance of such bonds in the secondary market.


The legal and regulatory framework governing AT-1 bonds in India is primarily focused on ensuring compliance with Capital Adequacy Ratio requirements set by the RBI, but concerns remain about the lack of protection for bondholders' interests. As unsecured creditors, AT-1 bondholders rank inferior to any other form of debt and are only superior to equity shareholders in the event of winding up a company. While SEBI has issued guidelines for the issuance of these instruments, mis-selling of these bonds to retail investors has been reported. Overall, there appears to be a need for stronger protections for bondholders in the legal and regulatory framework governing AT-1 bonds in India.


Challenges in Evaluating and Assessing the Risk of Perpetual Bonds


Perpetual bonds are a unique financial instrument that presents challenges in its evaluation and risk assessment. Typically, bonds are valued by discounting future interest receipts and principal repayments to present value. However, in the case of perpetual bonds, there is no principal repayment, and thus, the traditional method of valuation is not suitable. Additionally, perpetual bonds with no call-back option assumed to mature after a set period of time do not provide a precise measure of the bond's risk but are used for convenience.


SEBI recently issued guidelines to determine the maturity date of AT-1 bonds. Until March 31, 2022, these bonds would be assumed to mature after ten years from the date of issue, and this would gradually increase to 20 and 30 years in a phased manner to finally 100 years from April 2023. While this provides some clarity on the maturity date, it does not address the issue that the valuation still does not show the exact risk and value attached to the bond.


Furthermore, evaluating the bond by assuming that it would mature after 100 years of the issue makes it a highly volatile financial instrument. The mutual fund industry has significant exposure to these bonds, with a position of approximately holding Rs 35,000 crore of this debt instrument. This exposure presents a potential risk to the general populace and investors in such mutual funds who are saving for their personal uses such as retirement, education, personal saving, and others.


While the SEBI guidelines for AT-1 bonds provide greater clarity on the maturity dates, there are still concerns surrounding the consistency of these guidelines in terms of bond valuation. This issue mainly stems from the fact that the guidelines do not offer a comprehensive and uniform approach to valuing the bonds, especially after the 100-year maturity assumption takes effect. As a result, although the maturity dates are clearer, the inconsistencies in the guidelines create uncertainties in bond valuation, which could undermine the utility and effectiveness of these perpetual bonds in the financial market.


Moreover, perpetual bonds have been used as a tool to meet regulatory requirements, as they are considered to be a part of the issuer's equity rather than debt. However, the lack of clarity on the issuer's obligation to repay the principal and the coupon payments on the bond make it a risky financial instrument for investors.


From a legal standpoint, the lack of clarity on the maturity date of perpetual bonds presents challenges in assessing the issuer's obligations and investors' rights. In the absence of a definite maturity date, the bondholders may not be able to enforce their right to repayment. Similarly, the issuer's obligation to pay the coupon on the bond may also be subject to suspension, which presents challenges in assessing the bond's value and risk.


Moreover, perpetual bonds with no call-back option raise concerns over the validity of the assumption that the bond will be called back after a set period. It is important to note that call-back options are not an obligation, but an option for the issuer, and thus, relying on them as a basis for valuation may not provide an accurate assessment of the bond's risk.


Suggested Reforms


To provide greater protection for bondholders, the legal and regulatory framework needs to be revised to prioritize their interests. Currently, bondholders are often at the bottom of the repayment hierarchy in the event of winding up or insolvency proceedings, which exposes them to significant risks. Revising the order of repayment to give bondholders a higher priority, and requiring issuers to provide collateral or security to protect bondholders' interests, would go a long way in mitigating these risks.


However, these reforms would require significant legal and regulatory changes to be implemented effectively. One of the key challenges in this regard is the need to strike a balance between protecting bondholders' interests and ensuring the overall health of the financial system. It is also important to ensure that these reforms do not lead to unintended consequences, such as discouraging issuers from raising capital through AT-1 bonds altogether.


Another potential reform is to limit the use of perpetual bonds, which pose significant risks to bondholders, particularly retail investors who may not fully understand the risks associated with these instruments. While perpetual bonds may provide benefits to issuers, they also expose bondholders to an indefinite duration of risk. Setting a cap on the number of perpetual bonds that can be issued or restricting their use to specific sectors or industries can help mitigate these risks.


However, any reforms must also take into account the potential impact on the wider financial system. For instance, if perpetual bonds are restricted too much, this could lead to a reduction in overall capital levels, which could be detrimental to the stability of the financial system.


Finally, increased investor awareness and education programs can help prevent mis-selling of AT-1 bonds. While mandatory training for financial advisors and clear communication of risks in marketing materials can be effective in increasing awareness, it is also important to ensure that retail investors are able to make informed decisions about their investments.


Conclusion


The regulation of perpetual bonds in India is complex, with unclear maturity dates and a heterogeneous regulatory framework causing confusion and uncertainty for issuers and investors. The hybrid nature of these instruments as a mix of debt and equity adds further intricacy to their valuation and risk assessment. To address these challenges, a well-balanced approach is needed to protect the interests of all stakeholders and ensure financial system stability. Establishing clear guidelines and regulations and implementing reforms such as improving disclosure requirements, enhancing regulatory oversight, providing greater protection for bondholders, limiting the use of perpetual bonds, and increasing investor awareness can help achieve this goal.

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