Market yields on government bonds have been rising quite sharply in recent months, with short-term yields rising to narrow the gap with long-term yields. However, for investors with surpluses to invest for 2-3 years, the options are still somewhat limited.
Interest rates from leading banks on 2-3 year FDs are still stuck at 5-6 %, barely matching prevailing inflation rates. Bonds from top-rated corporates don’t yet offer sufficiently attractive spreads over g-secs. Returns on debt mutual funds in categories such as low duration or short duration, are still stuck in the 3-4% range and will take a bit of time to catch up with market interest rates.
In this situation, bonds from the government or quasi-sovereign entities seem to offer the best risk-reward equation currently.
As India’s largest public sector bank whose financials are on an improving trajectory, SBI is about as near to a quasi-sovereign entity as one can get. We recommend investing in the 2019-2020 tranches of AT1 bond issues from SBI traded in the secondary market, with call dates falling within 2-3 years. They can currently fetch you yields that are at a 60-70 basis point spread over central g-secs of similar maturity.
As AT1 bonds carry complex features and higher risks than plain vanilla bonds or government securities, they are suitable only for high net worth investors with a large bond allocation.
This recommendation is part of our coverage of privately placed or secondary market bonds for HNIs that we kicked off in March 2022. Do read our earlier article on these bonds to know the generic risks in taking exposure to them, as they are not freely traded in the stock exchanges.
This series of bonds may not be freely available in exchanges. They are typically are available through intermediaries or sub-brokers of such intermediaries – like wealth managers, family offices and so on. At PrimeInvestor, we are neither brokers nor sub-brokers. So, the only way for us to get information on such private placement is from the intermediaries. For this purpose, we have partnered PhillipCapital (India) Pvt. Ltd, a SEBI registered broker and clearing member of both NSE and BSE with presence in India for 21 years.
The account opening process is detailed here. Please note that we do not have any commercial agreement with Philip Capital (India) for the above. Our objective is only to make the bond accessible to you.
SBI perpetual bonds
We recommend investments in three tranches of SBI’s AT1 bonds issued between August 2019 and September 2020, carrying coupons of 7.74% to 8.75% per annum. The first call on these bonds will come up 5 years from the date of issue, and detailed below. If the call isn’t exercised then (which is unlikely), it can be exercised on the same date in every subsequent year.
These bonds belong to the earlier tranches of AT1 bond issues from banks, when RBI allowed minimum investments of Rs 10 lakh by individual investors. This allows HNIs to take exposure to these bonds without concentration risks. The minimum investment for more recent tranches of AT1 bonds has been hiked to Rs 1 crore.
The table below details the features of the three SBI tranches we recommend. The availability of these bonds may be subject to market liquidity.
As you can see, SBI AT1 bond yields based on the nearest call date are at spreads of 60-70 basis points over g-secs maturing in 2024. Please note that the real return to you is the yield and not the coupon rate. Current g-sec yields are captured below.
Please note that the minimum investment amount is Rs 10 lakh and in multiples of the same. Please be aware that you may not be able to immediately procure these bonds. You will need to check with Philip Capital (India) on the availability of these bonds and they will come back to you on the same.
SBI’s AT1 bonds, just like similar bonds from any other bank, are perpetual, non-convertible, unsecured, taxable Basel 3 compliant instruments. These bonds, in ordinary times, work like debt instruments paying their promised interest rate and are designed to do so perpetually.
But all AT1 bonds carry three kinds of risks:
# 1 The bank has discretion to skip paying out the coupon on the bond in case of a shortfall in its profits or reserves in any particular year. Earlier, banks could not pay out interest from accumulated reserves but this has changed recently, making the skipping of coupons a rare occurrence.
# 2 The bank can write down the face value of the bond in part or in full, if its financials should take a severe adverse turn in the form of large losses or write offs that shrink its capital base below regulatory norms. The principal value of AT1 bonds was completely written off when Yes Bank and Lakshmi Vilas Bank landed in financial troubles and were bailed out. Therefore, investments in AT1 bonds of shakier banks come with the risk of capital losses.
Coupon skipping provisions kick in if a bank’s CET 1 capital ratio falls below 8% and principal write off provisions apply if it falls below 6.125%.
# 3 All bank AT1 bonds in India are traded on the assumption that the issuing bank will exercise the call option at the end of 5 years. If the bank decides to skip the call option on the expected date and let the bond run, the market prices could react adversely, as yields of such bonds are priced on the assumption that these are 5 year, and not perpetual bonds.
In India, while there has been no case of a bank not exercising the call option, in 2017-18 several public sector banks called back their AT1 bonds ahead of the 5 year time frame, after they were placed under PCA. In such cases, the early call could upset your yield calculations though providing you with early exit.
However, the mere fact that something has not happened so far does not mean that it can never happen. So investors in AT1 bonds, especially in a rising rate scenario do need to budget for the call being delayed, in exceptional circumstances.
Why SBI perpetual bonds
AT1 bonds, because of their loss-absorbing features and call options, are inherently risky instruments. This is why AT1 bonds from banks offer higher coupons than their plain vanilla bonds and also carry a credit rating that is one to two notches below the plain bonds from rating agencies.
But having said this, SBI AT1 bonds offer a relatively safe bet compared to those of most other banks, making the calculated risk taking on higher yields worth it. We say this for two reasons:
#1 Sound financials
Most of the risks attached to the AT1 bonds – skipping of coupons, principal write-offs – materialise because of a bank facing mounting bad loans and write-offs and facing an eroding capital cushion. As India’s largest bank, well placed to capitalise on the improvement in the economy and credit offtake, SBI is today in sound financial shape.
At the time of the issue of these tranches of AT1 bonds in 2019-20, SBI on a standalone basis, was not in great financial shape. It had just managed a turnaround, from massive losses of Rs 6547 crore in FY18, to tentative profits after tax of Rs 862 crore in FY19. Its gross Non-Performing Assets (NPAs) and net NPAs at 7.53% and 3.01% respectively, were also at elevated levels, while capital adequacy ratios at 9.62% for CET Tier 1, 10.65% for total Tier 1 and 12.72% for total CRAR ratio, were only a little above statutory thresholds.
But despite the onset of Covid in 2020 and the loan moratoriums and delinquencies resulting from it, SBI’s financials have managed a substantial improvement in the three years since 2019. Apart from a sharp jump in net interest income and NIMs, SBI has seen a material fall in bad loans and loan loss provisions, leading to a big lift to its profitability.
This has led to its capital buffers improving to more comfortable levels above Basel 3 thresholds. Currently, SBI’s CET Tier 1 ratio at 9.94%, Tier 1 capital ratio at 11.42% and overall CRAR at 13.8% stand well above statutory requirements of 8%, 9.5% and 11.5% respectively. SBI AT1 bond holders therefore are at negligible risk of coupons being skipped or principal being written off at this juncture.
#2 Systemically important
After a big round of consolidation and mergers, SBI has emerged as by far the largest commercial bank in India with the Government of India holding a 57.6% equity stake. The bank is not only the bulwark of India’s financial system, but is also critical to the government’s nation-building plans.
SBI’s sheer dominance of the Indian financial system and its importance to systemic stability ensure that, even if its financials witness a slippage, it would witness swift recapitalisation from the government. Given the signalling effect that SBI’s actions have for bond markets and investors at large, it is unlikely to indulge in adventurism on skipping coupons on its AT1 bonds or skipping or deferring the call option at the end of 5 years.
Any disruption on this score would affect the ability of all PSU banks to raise money for their non-equity Tier 1 capital from the markets. This makes for relatively high certainty on SBI adhering to its first call dates on its AT1 bonds.
However, having said this, investors should act on this recommendation after assessing the bond’s suitability to their risk profile and liquidity and taxation needs.
- HNIs with substantial net worth and bond allocations, so that the Rs 10 lakh allocation to the SBI bond will not result in concentration risks. Ideally, this exposure should not exceed 10% of your overall portfolio
- Ability to hold bonds until their maturity date. Interim liquidity in AT1 bonds and in fact all privately placed bonds can be quite limited in the Odd Lots segment. You cannot assume that you will be able to exit these bonds before their call date. You will need to approach your dealer to see if the bond can be sold. There is also the remote risk of the call not being made at all.
- These bonds are not tax efficient. The interest payouts are taxed at your income tax slab rate, with the tax incidence the same as for your bank FD or conventional bond.
- PrimeInvestor has a non-commercial partnership with PhillipCapital (India) specifically for receiving information on bond issuances.
- PrimeInvestor does not receive, directly or indirectly, any commission or any other reimbursement in any form – from any of the parties involved in the issuance. We are not brokers nor distributors.
- PrimeInvestor is not involved in the onboarding process nor in the execution of these transactions and as such is not liable for any acts of commission or omission. We will be unable to take on any kind of operational queries regarding these transactions.
- Our responsibility is limited to recommending these products based on information available to the best of our knowledge. Despite best effort on due diligence, there is a risk of default in these instruments.
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