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AT-1 BONDS CONTROVERSRY
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- History of AT1 Bonds: The concept of AT1 bonds (additional Tier 1 bonds) was brought in after a bunch of global banks went bust during the global financial crisis and regulators formulated Basel III norms for banks. One of the key things Basel III did was to raise the amount of their own capital that banks needed to carry in their balance sheets, before they raised external deposits and loans.
- Indian banks: Basel III norms require Indian banks to maintain a total capital ratio of 11.5%, split into 8% in tier 1 capital (own equity, reserves etc) and tier 2 (supplementary reserves and hybrid instruments). The AT 1 bonds, also known as “unsecured subordinated perpetual non-convertible” bonds, make up part of a bank’s Tier 1 or permanent capital. Banks issue them to make sure they can meet Basel III norms on equity capital.
- Raising capital: Any company can raise funds via equity (shares) or bonds (debt). The AT-1 bonds are a midway between these two methods. AT-1 bonds do not have a maturity date. Some features of these are like equity, for example trading in stock markets. These are issued only by banks, and are inherently riskier compared to other bonds. These are bought by big ticket investors (each bond worth Rs.10 lakhs face value).
- Features: These are unsecured bonds which have perpetual tenure. In other words, the bonds have no maturity date. They have call option, which can be used by the banks to buy these bonds back from investors. These bonds are typically used by banks to bolster their core or tier-1 capital. AT1 bonds are subordinate to all other debt and only senior to common equity. Mutual funds (MFs) are among the largest investors in perpetual debt instruments, and hold over Rs 35,000 crore of the outstanding additional tier-I bond issuances of Rs 90,000 crore.
- Five features of AT-1 bonds that make them risky:
- Option not to call – When you invest in FDs or NCDs, you know the exact date the investment will mature. AT1 bonds have no fixed maturity date because they are perpetual bonds (perps) that remain with the bank as it needs the money. AT1 bonds are often (mis)sold as limited-period bonds because of the feature of call option by the issuer. AT1 bonds allow the issuing bank to voluntarily redeem them at the end of 5 or 10 years, if they have no need of the extra money. It is up to the bank to decide on the call option date, when it will pay back your principal or simply continue paying interest for perpetuity. Indian intermediaries and buyers often assume that the issuing bank will exercise its call option at the end of 5 or 10 years. The pricing and yields on these bonds have reflected this assumption. In December 2020, Andhra Bank in fact announced plans to skip the call option on its AT1 bond after five years, but changed its mind after market backlash. It is best that investors in AT1 bonds be prepared to treat these bonds as perpetual instruments given that this is part of their contract terms. This makes them unsuitable for fixed-date goals.
- Early recall on events – While the optional call after 5 or 10 years allows issuing banks to treat AT1 bonds as perpetual, they can also repay them sooner without checking with you. AT1 bonds include a clause in their terms that allows the bank to repay them prematurely, if a tax or regulatory event, not expected at the time of the issue occurs. So the AT1 bonds you hold maturing before you expect them to, resulting in reinvestment risk (the risk of finding similar-return instruments to invest your proceeds in). In March 2018, four public sector banks IDBI Bank, Oriental Bank, Dena Bank and Bank of Maharashtra that had issued high-yielding AT1 bond decided to use the ‘regulatory event’ clause to recall AT1 bonds, after their weak financials put them under RBI’s Prompt Corrective Action framework.
- Skipping interest – AT1 bonds differ drastically from fixed deposits or NCDs in that they can skip interest payouts, without creditors being able to sue them for default. The discretion to partly or full skip interest payouts kicks in the moment a bank’s Common Equity Tier 1 ratio (CET 1 ratio) falls below 8%. The contract terms also allow banks to hold back coupon payouts if they make losses and have insufficient reserves to meet the payout. Since AT1 are intended mainly to shore up the equity capital of banks, they incorporate clauses that allow the bank to skip interest payouts if its capital falls below the regulatory requirement when the interest is due. RBI has specified various threshold levels of CET1 (below 8%) at which the bank can reduce its interest payout by 60%, 40%, 20% or entirely for the year. So holders of AT1 bonds to watch the quarterly financial disclosures of their banks on CRAR, CET1 and profitability ratios like hawks, to verify the certainty of their returns. Intermediaries (who sell AT1 bonds) and investors (who buy them) take these clauses lightly, because no banks till date have exercised the option to skip coupons. The Government has hastily infused capital into some PSU banks so that they can meet interest payouts. But this cannot be reason for investors in such bonds to be unaware of the risks they signed up for.
- Principal write-downs – It is not just your interest payouts from an AT1 bond, but also your principal value itself that is at risk, if the bank’s financials turn dicey. A key contract term for all AT1 bonds relates to their ‘principal loss absorption’ feature. Simply put, the bank issuing the bond can write-down its face value (your principal) either temporarily or permanently, if its CET ratio falls below 6.125%.
- Point-of-non-viability – A deadly clause in all AT1 bonds is the absolute right, given to the RBI, to direct a bank to write down the entire value of its outstanding AT1 bonds, if it thinks the bank has passed the Point of Non Viability (PONV), or requires a public sector capital infusion to remain a going concern. This PONV clause is what has tripped up the holders of Yes Bank AT1 bonds. Though the bank’s last available financials did not indicate that it had breached the other CET1 clauses, the deterioration its financial position in the six months between September 2019 and March 2020 has apparently been so marked, that RBI has been forced to devise a bailout package for it. While doing this, RBI has also invoked the PONV clause. This is what has resulted in Yes Bank’s AT1 bondholders staring at a complete capital loss from their investments.
- SEBI 10th March 2021 circular
- No MF would own more than 10 per cent of AT1 bonds issued by a single issuer, (2) At the scheme level, the exposure to such instruments will be less than 10 per cent of the assets and less than 5 per cent towards a single issuer, (3) The maturity of perpetual bonds will be treated as 100 years from the date of issuance of the bond for valuation. (Currently, mutual funds value perpetual bonds as if they mature on their call date, which is the date when issuers might call back bonds and repay their investors)[Why this circular? Because of the AT1 writedown of YES Bank in March 2020, and inherent risk for MF investors. SEBI is for investor protection]
- Who buys these bonds: AT-1 bonds are complex hybrid instruments, ideally meant for institutions and smart investors who can decipher their terms and assess if their higher rates compensate for their higher risks. But in India, these bonds seem to have been sold to a fair number of retail investors as fixed deposit or NCD substitutes. AT-1 bonds carry a face value of ?10 lakh per bond. There are two routes through which retail folk have acquired these bonds — initial private placement offers of AT-1 bonds by banks seeking to raise money; or secondary market buys of already-traded AT-1 bonds based on recommendations from brokers.
- SEBI order March 2021: The SEBI told mutual funds to value these perpetual bonds as a 100-year instrument. This means that MFs have to make the assumption that these bonds would be redeemed in 100 years. The regulator also asked MFs to limit the ownership of the bonds at 10 per cent of the assets of a scheme. SEBI feels these instruments could be riskier than other debt instruments. It probably made this decision after the Reserve Bank of India (RBI) allowed a write-off of Rs.8,400 crore on AT1 bonds issued by Yes Bank Ltd after it was rescued by State Bank of India (SBI).
- So what’s the problem: Indian MFs have treated the date of the call option on AT1 bonds as maturity date. Now, if these bonds are treated as 100-year bonds, it raises the risk in these bonds as they become ultra long-term. This could also lead to volatility in the prices of these bonds as the risk increases the yields on these bonds rises. Bond yields and bond prices move in opposite directions and therefore, higher yield will drive down the price of bond, which in turn will lead to a decrease in the net asset value of MF schemes holding these bonds. Investors may rush to redeem these. Since these bonds are not liquid and it will be difficult for MFs to sell these to meet redemption pressure, mutual fund houses will engage in panic selling of the bonds in the secondary market leading to widening of yields.
- State banks will be hit hard: AT1 bonds are the instrument of choice for state owned banks as they strive to shore up capital ratios. If there are restrictions on investments by mutual funds in such bonds, banks will find it tough to raise capital at a time when they need funds in the wake of the soaring bad assets. A major chunk of AT1 bonds is bought by mutual funds. State banks have cumulatively raised around $ 2.3 billion in AT1 instruments in 2020-2021, amid a virtual absence of such issuance by private banks (barring one instance) in the aftermath of Yes Bank’s AT1 write-down in March 2020.
- What will happen finally: SEBI may relent, and withdraw the circular. Or some midway solution may be found. But it is highly unsavoury to see the government directly take on a reputed regulator, and that sends a negative message.
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