- SFB financials may look better than mainstream banks, but their lending operations are quite risky
- We identify three of them based on financials and disclosures
- SFB deposits are good as a diversifier and not as capital protection vehicles
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.
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 bond(s) 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.
25 thoughts on “What they didn’t tell you about perpetual bonds (AT1 bonds)”
The YES Bank cheated me in the name of Fixed interest BONDS which I was told secured then FDR with slightly more yield of 9% against 8.25 with Fixed maturity date which I was getting from BOI where I was having FDR of Rs.20 lacks out of my retirement benefits. This happened in March 2019. How ever, with in period less than one year I came to know through media that YES Bank has written down AT1 BONDS. Since I was holding Fixed interest BONDS I was not worried. How ever in JUNE 2020 When I enquired about my investment I was told that these BONDS have also written down with out notice being AT1 BONDS which was never told me by YES Bank executives who canvassed this business. This is how I was misled by this Bank. So far I had lodged 10 complaints with banking OMBUDSMAN giving evidences of cheating but were closed on filmsy grounds. I am again and again repeating that my complaint is Admissible under chapter IV item no 8w of your scheme 2006. They are not responding to it. Our Government authorities/Regulators are silent about it. This is how our system is functioning and allowing the CHEATER YES Bank to flourish. I am also share holder of this Bank but I am of a firm opinion that no Bank can survive by eating its own deposits by misleading the own depositors.
Very nicely explained for retail investors with hard facts and the risk of investment. Can you pls explain the risk of investment in Tier II bonds of banks, like Karnataka Bank.
one of the best articles on perpetual bonds. Currently, do you see, any risk even in SBI perp bonds, coupon skipping event ??
Thanks..unlikely top psbs will skip coupon given that they need to frequently knock at investors doors!
Nice presentation , will be more helpful to general investor if some options/examples are suggested for buying AT1 bonds of good banks.
Right now we think they are risky products to own as coupons may be skipped. However will keep the suggestion in mind for future.
How does retail investor invest in Perpetual bonds ?? I have ICICI Direct demat account .I am interested in investing in HDFC bond issue whenever it hits the market
Hello Sir, Please check with your broker and ask them to sound you off. Also, they will be available ins econdary market through stock exchanges. thanks, Vidya
Now South Indian bank giving yield close to 12 percent. Is there any risk involved in it like AT1 bonds? It is tier 2 unsecured subordinate debt instruments. Should I invest in it ?
I would to like to invest in bonds. Suggest me if any . Thanks for the blog.
Tier 2 bonds rank above AT1 bonds but below all depositors and other loans carried by the bank. They usually carry conditions that allow coupon to be skipped and principal to be written off if RBI decides that the bank has reached a point of non viability. They also have issuer call options that can reduce the yield. So yes, they are risky instruments. In the current circumstances it is best to stick with bonds of top tier banks
Please don’t be foolish in asking for these bonds.
My parents lost 1 cr plus and I know several ppl whose savings are wiped out completely
Google “Yes bank AT1 misselling” and you’ll know exactly what can go wrong
Thanks for the informative article Aarati. Is it normal for AT1 bonds to be treated as subordinated to equity as well? I can understand them being subordinated to the FDs and other deposits but couldn’t understand why the AT1 bondholders didn’t get equity when existing equity holders were not wiped out?
That’s a good question. While original RBI regulations make equity subordinate to AT1 bonds on liquidation, the offer terms for these bonds explicitly.allow write off ahead of equity if RBI sees threat of non viability. This clause was invoked for Yes Bank.
Fabulous article. Thanks Aarti
Welcome, glad you liked it ?
Glad you liked it ?
Dear Aarati
Good article. The next step for Primeinvestor is to identify such instruments in advance and inform the retail investors about their risk.
You should name such articles ‘What they DO NOT tell you about…………”.
Yes your feedback is well taken. Will try to do this on future.
For last few days AT1 bonds were mentioned in financial columns of newspapers. As a regular reader of these columns I am interested to know about these AT1 bonds. This article told in simple terms what these AT1 bonds mean and their risk and return to common investor for whom the above are not told by the sellers of these instruments.
Thanks for timely articles that are being published.
Welcome!
Thank you Aarati, for your detailed analysis.
A direct question to you, would you be tempted to invest in Public Sector Bank bonds like SBI, BOB etc if the yield were around 12 percent.
I would invest :-)because I’m an investor with a high risk appetite. Plus in today’s circumstances the govt will not like these banks to default on coupon. But only top 2 banks would make the cut.
In YES Bank case Regards to AT1 BONDS is TOTALLY fraud committed by its executives in order to lure senior Citizens. What was the modus operandi? The YES Bank executives targeted senior citizens to exploit them that they have a product which is safer and secured than FDR which you are having in the form of FDR. They canvassed this business by misleading that these BONDS have definate maturity date and ASSURED Fixed annual interest. The executives of YES Bank never told that these are perpetual BONDS/ AT1 BONDS but sold it as Fixed interest BONDS with the features mentioned above. There are verifiable evidences that how they colluded with SECONDARY MARKET and purchased these securities from the Broker. The Yes Bank as well as Regulators aren’t not coming forward to investigate this issue on filmsy grounds. The RBI is party to write off these securities with out any notice in March20. The Organization which claimed that it is a Wealth PROTECTOR has helped YES Bank to swallow hard earned money of senior citizens. This is shame what happened to the money of retirement benefits of Senior citizens by misleading them. Any how COURTS will do justice by taking time which is understandable
Is there any clause in IT act under which the loss on account of writing down of AT1 bonds of yes bank can be treated as normal CAPITAL loss and offset against gains in equity market either short term or long term ? Further -Can the loss of interest also in some way be set of against interest earned on normal deposits.
As there is no precedent of AT1 write off before Yes Bank there is no specific provision. But the point is logical and best you consult a tax advisor/CA on allowability of setoff as it may be subject to case law.
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