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.