Prime Bond recommendation: An AT1 bond with high yield

Update as on 29 December, 2022: This bond offering is now closed for further investments. Please check Prime Bonds for recommendations that are available currently.

At PrimeInvestor, we took an ultra-conservative approach to debt investments during Covid and just after it. But with economic recovery taking root, interest rates rising and credit offtake improving, we believe investors can shoot for higher yields by taking on some credit risk. Perpetual bonds from banks with sound financials are one option, offering good reward for risks taken.  We are covering one such bond here.

AT1 Bond recommendation

Investors with a high-risk appetite can consider an investment in IndusInd Bank’s AT1 bonds (perpetual bond) issued in March 2019. The bonds, which are listed, unsecured and subordinate debt were issued to help IndusInd Bank comply with Basel III requirements on capital. The details are as follows. 

• The bond offers 10.5% coupon rate.
• These bonds have a call option coming up in March 28 2024. 
• They are available at an estimated yield-to-call of 8.85% from PhillipCapital (India) Private Limited. This can change at the time of your purchase. You need to write to PhillipCapital (India) to check the present yields. The minimum investment size is Rs 10 lakh, making the bond suitable only for HNIs. 
• To offer privately placed bonds and other traded bonds that are seldom in the radar, we have a non-commercial arrangement with PhillipCapital (India) Private Limited to get details of such bonds. That means we do not earn anything from this nor are we operationally involved. You can read more about this and how we select such bonds here: https://staging.primeinvestor.in/varsity/our-coverage-on-private-bond-placements/
• If you have not done it earlier, you need to register with PhillipCapital (India) as a counterparty, with your KYC details to purchase these bonds. This is a one-time process and the details are given here: Investment process for the bond

Why IndusInd

With market interest rates moving up, yields on perpetual bonds issued by banks to meet their Tier 1 capital requirements have also risen in the last year or so. But the debt market has always made a significant distinction between AT1 bonds issued by public sector banks and those issued by private sector ones. Irrespective of the bank’s financials, public sector bank AT1 bonds tend to trade at relatively low spreads over g-secs of a similar tenure, because they are perceived to be sovereign-backed. 

Currently, yield on g-secs with maturity in 2024 trade at a yield of about 6.7% in the secondary market. AT1 bonds from SBI, Bank of Baroda and PNB maturing in 2024 and 2025 trade at yields-to-call of 7.75 to 7.95%, a spread of about 105-125 basis points over these g-secs.  Yield-to-call is the yield on the bond calculated on the assumption that the bond will definitely mature on the call date (this is a risk, read why below).

IndusInd Bank’s AT1 bonds trade at a yield to call of 8.85%, offering a spread of over 210 basis points over g-secs of a similar tenure (on call) and about 100 basis points over public sector banks. The higher yield on the IndusInd Bank AT1 bond is also a function of its slightly lower credit rating, at AA (Stable) by CRISIL compared to AA+ for SBI, Bank of Baroda, Axis Bank, HDFC Bank and the like. But this does not necessarily add to the credit risk as IndusInd’s bank’s financials compare quite well with public sector peers and leading private banks.

The call option due in March 2024 curtails risk, as the bank’s financials are unlikely to change materially in the home run to the call date. You can read CRISIL’s rating note here.

Improving financials

With a significant exposure to vehicle loans, wholesale corporate loans and microfinance, IndusInd Bank faced significant headwinds during the onset of Covid. Between Q4 FY19 and Q4 FY20, its corporate loan growth fell sharply, even as delinquencies (gross NPAs) spiked. This prompted the bank to set aside high contingency provisions during this period, which dented profitability and return ratios.

But with the bank managing to ward off a significant NPA crisis, and shoring up capital buffers, its loan book growth, NIMs and other metrics have staged a strong bounce-back since FY21. While its corporate loan book (with exposure to real estate, hospitality and jewellery) is riskier than leading private banks, loan growth in a credit upcycle as well as strong capital buffers offer cushions.  

The recent upturn in credit offtake on the commercial and corporate segments has helped the bank deliver strong growth in the past year, further improving its margins and return ratios. 

With the business in good shape, and CRAR and CET1 ratios, at 18.01% and 15.97% - well above regulatory requirements of 11.5% and 8% respectively, the risk of IndusInd skipping coupon payments or taking write-downs, appears quite limited for now.  

The risks in AT1 bonds

However, investors betting on AT1 bonds do need to be aware that these bonds are very different from vanilla NCDs. 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 that shrink its capital base below regulatory norms. RBI can also decide to write down the value of such bonds to zero if it perceives risks to the bank’s viability. 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. IndusInd Bank has exercised the call option on the previous tranche of 9.50% AT1 bonds issued in 2017, in February 2022. 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, 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. Investors in AT1 bonds, especially in a rising rate scenario do need to budget for the call being deferred or skipped, in exceptional circumstances. In such a case, coupon payments will continue, though yield and liquidity can take a significant hit. For a detailed understanding of how AT1 bonds work, do read our earlier article.

Given these risks, we recommend that the bonds be accumulated only by investors with a sufficient net worth to absorb losses, if any. As a risk containment strategy, do ensure that exposure to these bonds does not exceed 5% of your overall portfolio. 

If you wish to know more details, you can solicit interest by writing to Phillip Capital (India) in the contact given in this article.

Disclaimers

1. PrimeInvestor has a non-commercial partnership with PhillipCapital (India) specifically for receiving information on bond issuances. 
2. 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. 
3. 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. 
4. 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. 
5. PrimeInvestor is a SEBI registered Research Analyst (Registration: INH200008653). The content and reports generated by the entity does not constitute or is not intended to constitute an offer to buy or sell, or a solicitation to an offer to buy or sell financial products, units or securities. All content and information are provided on an ‘as is’ basis by PrimeInvestor Financial Research Pvt Ltd. Information herein is believed to be reliable but PrimeInvestor Financial Research Pvt Ltd does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. The services rendered by PrimeInvestor Financial Research Pvt Ltd are on a best-effort basis. PrimeInvestor Financial Research Pvt Ltd does not assure or guarantee the user any minimum or fixed returns. PrimeInvestor Financial Research Pvt Ltd or any of its officers, directors, partners, employees, agents, subsidiaries, affiliates or business associates will not liable for any losses, cost of damage incurred consequent upon relying on investment information, research opinions or advice or any other material/information whatsoever on the web site, reports, emails or notifications issued by PrimeInvestor Financial Research Pvt Ltd or any other agency appointed/authorised by PrimeInvestor Financial Research Pvt Ltd.
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