A case for perpetual bonds

Sebi’s move to better regulate market discipline in the issue of AT-1 bonds will lead to informed investment decisions

By Author Dr K Srinivasa Rao   |   Published: 31st Mar 2021   12:12 am

Perpetual bonds, also known as AT-1 bonds, are drawing attention with the Securities and Exchange Board of India (Sebi) issuing fresh guidelines to protect retail investors. Issued by banks under ‘Alternate Tier-1 (AT-1) bonds, these can be in the form of non-cumulative preference shares and/or perpetual debt instruments. They have no firm maturity date but can be traded in the secondary market; hence carry better interest rates with inherent risks. Going by the letter and spirit of introduction of AT-1 bonds by the Basel Committee on Banking Supervision as part of the Basel-III framework, the term of issue of AT-1 bonds and associated risks have to be understood to make an informed investment decision.

AT-1 perpetual bonds are intended to absorb the risks of issuing entities. The explicit requirement of perpetual bonds is a kind of debt instrument issued by banks to augment capital that can fully absorb losses at the so-called point of non-viability before taxpayers are exposed to loss. Thus AT-1 bonds are specially aligned with loss absorption capacity that needs to be understood and the investors should be conscious of the higher risks coming from higher yields. The investor education of these specially crafted securities needs to be well disseminated and institutionalised by fund managers.

Loss Absorption

The risk sensitivity of AT-1 bonds glaringly came to the fore when Yes Bank wrote off its AT-1 bonds of Rs 8,415 crore as it went through the unprecedented existential crisis, a rare occurrence. A look at the composition of capital of banks will demystify the order of riskiness of securities floated to access capital.

Banks after Basel-III implementation have three levels of capital to absorb losses: (i) Tier-I, the ‘Core Equity’, is the highest quality of regulatory capital as it absorbs losses immediately when they occur. (ii) Alternate Tier-I capital ranks next and hence, AT-1 bonds are floated with perpetual tenor but have higher coupon rates (interest rates). AT-1 instruments are meant to absorb losses while the entity is ‘on a going-concern basis’. (iii) In contrast, Tier-II capital is ‘gone-concern’ capital. That is, when a bank fails, Tier-II instruments must absorb losses before depositors and general creditors do. Obviously, the criteria for Tier-II inclusion are less strict than AT-1 bonds. The capital raising securities floated under Tier-II have a maturity date and interest rates that may usually be less than on AT-1 bonds that have more uncertainty with no maturity date.

Looking to the sensitivity towards higher risk, the issuers of AT-1 bonds will have to combine enhanced disclosure requirements aimed at improving the transparency of banks’ capital bases, improving market discipline. Any attempt to shield the riskiness of AT-1 instruments ultra vires the basic tenets of the issue. Based on the concept of risk-based yield, AT-1 bonds have a better yield when compared with other securities in the market. When the yield is high, investors must be cautious that risk will be high.

Hence, AT-1 bonds are perpetual by nature with no ‘put option’ but the issuing entity may, at its discretion, offer a ‘call option’ of 5 or 10 years to make them attractive. In normal banking practice, even AT-1 bonds are redeemed by the issuing entities and assure full protection to the investors but when a crisis arises, the first line of debt instruments are perpetual AT-1 bonds to go.

AT-1 bonds even now are equally popular with outstanding perpetual bonds in the banking system working out to Rs 1 lakh crore. When the going is good, the investment is an attractive avenue for a better return to deploy savings though downside risks cannot be ruled out. Of the total stock of AT-1 bonds, mutual funds are said to be carrying exposure of Rs 35,000 crore.

perpetual bonds

Sebi’s Move

Market regulator Sebi, based on the experience of Yes Bank, had originally proposed to increase the rigour and treatment of AT-1 bonds from April 1, 2021, by considering the tenor of these instruments as having 100 years maturity; restricting the exposure of mutual funds to 10% of asset value and to single entity up to 5% of its asset value.

After the modified Sebi guidance, the deemed residual maturity of the perpetual bonds shall now be 10 years (instead of 100 years, originally contemplated) until March 2022. But the presumptive residual tenor will gradually be raised to 20 and 30 years in the subsequent six months to reach 100 years (as originally envisaged) from the date of issue, effective April 2023. It will provide enough time for the investors and fund managers to set their risk appetite and adjust their debt portfolio. Keeping the larger interest of stakeholders and likely market disruptions in the near term, Sebi slightly softened its stance.

Capital Raising

Post the implementation of Sebi norms, banks may find it difficult to get AT-1 perpetual bonds’ buyers in future at current rates of interest. It may elevate fundraising costs in the near term. But, market players and investors will get time to readjust their risk appetite. At the same time, making investors aware of the enhanced risks in subscribing to them should also be appropriately passed on as part of investor education. Given the fact that AT-1 bonds hardly constitute one per cent of risk-weighted assets of the banking system, the prospective tightening of the norms would not jeopardise the process of capital raising of banks adversely.

Even after the Yes Bank write-off, State Bank of India, Bank of Baroda and Indian Bank have raised capital by issuing AT-1 bonds. Moreover, the eventuality of write-off or non-servicing of AT-1 bonds is rare given the sturdy regulations and investor awareness. The present calibrated approach to better regulate the market discipline in the issue of AT-1 bonds will pave the way for informed investment decisions in future. The Sebi mandate has once again highlighted the doctrine of ‘Caveat emptor’ (let the buyer beware) for all stakeholders even in assessing and understanding the nuances of risks inherent in emerging innovative securities open for investment.

(The author is a former General Manager, Strategic Planning, Bank of Baroda. Views are personal)

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