On 12th April, the Securities and Exchange Board of India had imposed a penalty of Rs 25 crore on Yes Bank and three of its senior executives for allegedly perpetrating a fraud on its customers by influencing them to alter their investment positions from fixed deposits (FD) to AT-1 bonds representing them as “Super FD” and “as safe as FD.”

Before getting into the details of the catastrophe that the Peps (AT-1Bonds) caused in terms of financial loss to the investors, first things first. It was the failure of a bunch of global banks during the economic crisis of 2008 that led regulators to formulate the Basel III norms to improve the quality and quantity of regulatory capital of banks.

As a sequel to this and taking a more prudent stance, RBI directed Indian banks to maintain a minimum total capital ratio of 11.5%—including a capital conservation buffer of 2.5%—of total risk weighted assets split into Tier1 capital of 8% consisting of equity, reserves, etc., and Tier 2 capital of 3.5% consisting of supplementary reserves and hybrid instruments.

It is to meet these Basel III norms that banks have come up with the novel idea of raising capital by issuing “unsecured subordinated perpetual non-convertible bonds”. And Indian banks too, taking a liking to the concept, said to have issued perpetual bonds to the tune of about Rs 84,000 crore to meet their capital requirements under AT-1 of the new regulations.

As the name indicates, perpetual bonds do not carry any maturity date. Which means, the issuer had no obligation to pay them back ever to the investors. They, of course, offer to pay a coupon or interest to buyers of these bonds at a fixed date perpetually. As they are of perpetual nature, issuers usually offer higher coupon rate than the prevailing rates on banks’ fixed deposits, etc.

However, these bonds come embedded with several risks. The first and foremost is the default risk: banks can write-off the AT-1 bonds and also stop paying interest on them if they run short of capital or face bankruptcy. Some issuers may attach a call option to these bonds. Such a call option gives Banks a right to buy back the bonds at the end of the specified period of say, 5/10 years after the issue date. But issuers seldom exercise this option, for interest rates may not fall so drastically making these bonds expensive for banks.

Investors can, of course, exit from these bonds by trading in the secondary market. But in a scenario of rising inflation/interest rates, they are to be sold at a discount to the face value. Thus, investors in these bonds suffer from inflation/interest rate risk too.

Of course, it is only after the YES Bank crisis, which involved a write-off of its AT-1 bonds worth about RS 8700 crore issued by it earlier, that all these risks associated with Perpetual bonds came to light. Indeed, investors had realised that AT-1 bonds are worse than even equity! For, the equity of Yes Bank was maintained intact, while it was only the perpetual bonds that were permitted to be written off by the regulator, RBI. The investor’s money under fixed deposits of the bank too was maintained intact except for a temporary restriction on withdrawal.

Alerted by the Yes Bank saga, market regulator, SEBI, looked afresh at the complexity of these bonds, particularly their valuation. Once alerted, as a first step to protect retail investors in debt mutual funds, SEBI imposed a limit of 10% for debt funds to invest in AT-1 bonds. Secondly, noticing a lacuna in the valuation of these bonds by MFs, SEBI ordered them to value these bonds as if they were 100-year bonds as against the current practice of valuing them as though of 5/10 year bonds, assuming that issuers would exercise their call option, to reflect their true risk.

This has obviously stirred up a hornet’s nest: MFs have raised a hue and cry, for the net asset value of several debt schemes are likely to get eroded drastically if this method of valuation is adopted now. Finally, being frantically lobbied by debt MFs, the Finance Ministry requested SEBI to review the instructions given for valuation of AT-1 bonds.

Accordingly, SEBI has now proposed to reset valuation in three phases: till March 2022, residual maturity of AT-1 bonds may be valued at 10 years maturity from the date of issue; during the first half of 2022-23 residual maturity will be reset to 20 years; in the second half of 2022-23 it will be extended to 30 years and finally, from April 2023, bonds will be valued at 100 years maturity.

This rearrangement will, of course, give the much-needed succour to debt MFs, but this whole fiasco posits a battery of questions: How is it that the MFs did not realize this simple valuation challenge and its impact on their NAV while investing in these bonds? How the rating agencies failed to take cognizance of the embedded risks while rating these issues? And importantly, how the regulator, SEBI failed to anticipate the complexities of Peps? And of course, the last yet an important question is: How NPA-saddled PSBs will now shore up their Tier 1 capital?

That aside, ironically, SEBI has now imposed a fine of Rs 25 crore on Yes Bank for mis-selling additional Tier -1 (AT-1) bonds—“devious scheme to dump the AT-1 bonds on their hapless customers”— to individual investors. Sadly, most of these investors were said to be senior citizens. This, of course, is of no avail for the investors since the YES Bank has long back written off the entire amount collected through these bonds from their books, and the investors, including retail investors lost their investment in full once for all. At best, this may warn future issuers of such bonds not to resort to such “dubious marketing techniques”.

Thus, our regulators being what they are, this whole episode once again reiterates that investors must take care of themselves. Simply put, they should be more careful while investing in the esoteric financial instruments—must enquire, read the prospects well and understand thoroughly the risk profile of the instruments before committing their money for such investments.