21 Feb

Additional Tier-1 Bonds

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Contents

• What are AT-1 Bonds?
• Why the risks for investors?
• How are AT-1 bonds triggered?
• AT-1 Bond in India
• Recovery in AT-1 bond system in India

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What are AT-1 Bonds?

• AT-1 bonds are perpetual debt instruments issued by banks to raise money and build up their core equity capital. There is no maturity date, implying that the issuer doesn’t pay the principal amount back to investors but makes periodical interest payments throughout the life of the bond.
• ‘Call Option’: In practice, AT-1 bonds typically come with a ‘call option’, which means that the bank issuing these instruments can redeem them or repay investors after a specified period.
• These bonds were introduced according to Basel banking norms made after the Global Financial Crisis. These are a form of “contingent convertible (cocos)” bonds which were created to prevent the need for government-funded bail-outs of precarious banks.

Why the risks for investors?

• Some features of AT-1 Bonds make them riskier than several other bonds.
  • AT-1 Bonds have equity like characteristics (quasi-Equity instruments), which permit banks to absorb losses.
    • If the bank faces financial stress, with capital requirement dropping below a specific levels, the covenants of AT-1 bonds typically permit the lender to hold off on interest payments or pay a lower amount. The bonds may also be converted into equity, helping to preserve the capital.
    • Some provisions allow the banks to write-off AT-1 bonds in case of severe financial crisis.
    • Further, AT-1 bond investor (unlike other bond investors) are not at the top of pecking order when it comes to receiving pay-outs from a bank facing financial stress. In fact, details sometimes put equity investors above than the bond investors.

How are AT-1 bonds triggered?

• These have different trigger mechanisms:
  • For e.g. if the Bank’s capitalization level falls below a preset threshold, the bond may be converted to shares, which eliminates bank’s liabilities on the AT-1.
• To compensate for these risks, banks pay investors a higher rate of interest for AT-1 bonds than other debt instruments or deposits.

AT-1 Bond in India:

• How much are the AT-1 bond holdings of Indian Banks?
  • Indian Banks don’t depend on AT-1 bonds much.
    • In a study, brokerage firm Macquarie sad that while India’s PSU banks have an exposure of 1-2 percent to AT-1 bonds, private sector banks only have an exposure of 0-1 percent.
  • The Indian market for AT-1 bond was upended in March 2020 following the crisis in Yes Bank.
    • Following severe financial stress, RBI and Yes Bank had decided to write-off additional tier-1 (AT-1) bonds worth Rs 8,415 crores. Mutual funds were amongst the biggest sufferers.
    • This was challenged in the court, and Bombay High Court in Jan 2023 ordered quashing of the write-off. But in Sep 2023, Finance Ministry has moved to the Supreme Court against the order.
• In 2021, SEBI amended valuation rule for perpetual bonds.
  • Residual maturity of Basel-III AT-1 bonds will be 10 years until 31st March 2022.
  • It will be 20 and 30 years for subsequent six months.
  • From 1st April 2023, the residual maturity of AT-1 bonds will become 100 years from the date of issuance of the bond
• SEBI then provided a phased timeline for mutual funds to value AT-1 bonds as 100-year instruments.
  • The 100 year valuation kicked in from 1st April, 2023.
  • Before this, AT-1 bonds were valued according to the call options on the papers – generally 5 to 10 years.
  • Impact: Huge decline in mutual fund investments in AT-1 bonds as a 100-year valuation lead to very sharp movements in market yields of such papers.

Recovery in AT-1 bond system in India:

• With improvement in banking sector in the form of reduced NPAs, the risk perception surrounding AT-1 bonds improved. In FY23, banks issued more than Rs 33,000 crore worth of AT-1 bonds.

Note:

• AT-1 bonds are subordinate to Tier-2 bonds.
• Tier-2 Bonds are subordinate to unsecured creditors, banks depositors, and senior bonds. They are not perpetual instruments. They have a maturity period of minimum 5 years.