What they didn’t tell you about AT1 bonds (perpetual bonds)

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  • AT1 bonds are designed to be part of permanent equity for banks
  • They can skip interest if the banks’ capital ratio falls below 8%
  • They need not mature in 5/10 years
  • They can write down your principal, temporarily or for good
  • They’re wholly unsuitable for regular income or capital safety goals

RBI’s rescue package for Yes Bank, which will see SBI infusing capital into the bank to pick up 49 % of its equity, offers a breather to its depositors and shareholders. But one class of stakeholders who are set to take a comprehensive haircut valued at Rs 10,800 crore despite the bailout, are the holders of Additional Tier 1 (AT1) bonds in the bank.

Social media posts reveal that these bonds are held, not just by mutual funds and wealthy investors, but also by retail folk and retirees who have been caught completely unawares by the 100% write-off. Retail investors who acquired these bonds seem to have been told that AT1 bonds are high-return substitutes to bank fixed deposits or non-convertible debentures.

Nothing could be farther from the truth. Given their ability to skip interest payouts without any consequences and write down their principal at any time, AT1 bonds are as risky or even riskier than (as Yes Bank has shown) equity investments. There are five features of AT1 bonds that make them highly unsuitable for retail investors seeking capital safety and fixed income.

AT1 bonds

What’s AT1 bonds?

The concept of AT1 bonds or 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.

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 point to note here is that 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. 

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Nothing fixed

So why are AT1 bonds, despite having a face value and a fixed coupon rate, not like fixed deposits or garden variety bonds? Because of the following five features.

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 that are supposed to remain with the bank as it needs the money. 

AT1 bonds are often (mis) sold as limited-period bonds because of one feature that they all incorporate – a 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. Given that the call option is voluntary, 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.  

In the Indian markets though, intermediaries and buyers of these bonds often take it for granted that the issuing bank will definitely exercise its call option at the end of 5 or 10 years. The pricing and yields on these bonds have traditionally reflected this assumption.

While both banks and policymakers have been quite wary of skipping the call option, sooner or later, it is quite likely that a bank will choose to exercise this right. In December, 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.

Market perceptions notwithstanding, 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.     

This can lead to 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. 

The early recall also caught folks who had bought these bonds from the secondary markets at premiums by surprise as redemptions through call happen only at face value.

Skipping interest

 A key feature on which AT1 bonds differ drastically from your fixed deposits or NCDs is 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. 

Given that 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. 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%. 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. The contract terms also allow banks to hold back coupon payouts if they make losses and have insufficient reserves to meet the payout. This makes it critical for 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. 

Both intermediaries who sell AT1 bonds and investors who buy them often 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

On top of all the above, there is also a clincher clause in all AT1 bonds that can deal investors a nasty surprise. This 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. 

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.

Summary

All the above factors illustrate why retail investors need to think hard before taking a leap of faith on AT1 bonds, no matter how attractive their returns. Until now, a false sense of complacency about their clauses has led to their primary offers being priced at coupon rates of 9-11 per cent.  Market intermediaries often highlight the spreads that these bonds offer over NCDs or bank fixed deposits while placing them. But that’s like comparing chalk and cheese.   

Lapping up AT1 bonds from the secondary markets at high Yield-to-Maturity is even more fraught with risk. Bonds trading at high YTMs are likely to be below their face value, reflecting the markets’ high-risk perception of the bank. When a bank’s finances deteriorate, liquidity can also evaporate in a trice.

Overall, you shouldn’t be buying AT1 bonds at all if regular income and capital safety are your priority. You can consider AT1 bonds from the very sound, top three or four banks after checking out their credit ratings, if you have appetite for equity-like risks.  

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20 thoughts on “What they didn’t tell you about AT1 bonds (perpetual bonds)”

  1. one of the best articles on perpetual bonds. Currently, do you see, any risk even in SBI perp bonds, coupon skipping event ??

  2. Nice presentation , will be more helpful to general investor if some options/examples are suggested for buying AT1 bonds of good banks.

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