Bank fixed deposits are traditional, vanilla investments in banks, fetching a pre-stated interest rate, having a definite maturity date. The banker is obliged to return the matured deposit only when the depositor demands it. Such deposits have limited liquidity till maturity, with only the banker being authorized to pre-maturely return the deposit, subject to conditions that include a lower than contracted interest rate.
The Role of AT-1 Bonds in Strengthening Bank Capital Base
Banks also have other borrowings. These may be from the Reserve Bank, other banks and institutions, or from the public. One interesting borrowing is through AT-1 bonds.
Additional Tier-1 bonds (or AT-1 bonds), called COCO Bonds – Contingent Convertible Bonds in Europe, are a type of unsecured, perpetual bonds that banks issue to shore up their core capital base to meet the Basel-III norms. As banks became part of globalization the risks of their failure infecting the entire global business systems were considered by global central bankers. They addressed them with a series of regulations generated in the cozy town of Basel in Switzerland, starting with Basel 1 norms in 1988 that applied only to internationally active banks of G10 nations. Basel 2 in 1994 considered market risk, discipline, and capital requirement for banks. In 2009, subsequent to the Global Financial Crisis Basel 3 prepared to promote a resilient banking sector with stronger global capital and liquidity regulation. The objective was to improve the banking sector’s ability to absorb shocks from financial and economic stress. Enhanced capital requirements, including AT-1 bonds, were a part of these regulations.
AT-1 bonds are different from plain-vanilla bonds. The bonds have a market lot of Rs. 10 lakhs and are perpetual (they have no maturity date). They have call options that allow banks to redeem them after every five years, as disclosed in the terms of the bond issue. There are no put options to allow investors to demand that the bank return their money. Banks are not obliged to exercise the call option and can opt to pay only interest on the bonds. The banks issuing AT-1 bonds can skip interest payouts for a particular year or even reduce the bonds’ face value if their capital ratios fall below certain threshold levels (this can happen if bad loans increase and are to be provided for). If the RBI believes it is warranted, it can simply ask the bank to cancel its outstanding AT-1 bonds without consulting its investors. This has happened to ₹8,415 crores of Yes Bank’s AT-1 bonds.
AT-1 bonds are quasi-equity instruments, which means that they are treated as equity but have priority during liquidation of the bank. The treatment of the Yes Bank AT-1 bonds as inferior to equity by the RBI has been taken to the law courts. The RBI says that Yes Bank was not liquidated, but saved by State Bank of India and others in a “resolution”. (While the cancellation of the Yes Bank AT1 bonds is sub-judice it has shaken my firm faith in RBI thinking through on its actions. The highest risk investor, in equity has been bailed out at 500% of the face value of the instrument – Rs. 2 shares bought out by the SBI and others at Rs. 10, those with a lower risk instrument taking a hit is neither logical, not economically just).
Understanding the Risks and Rewards of AT-1 Bonds
Besides the risk of the AT-1 bond being canceled in case of a loss, or interest being skipped, the risk of prepayment exists. Getting back our money when the investment is earning a good return leaves us looking for places to reinvest it! During the 2017-18 11 banks, even those under the RBIs Prompt Corrective Action (PCA) prematurely redeemed their AT-1 bonds. So far, no bank (barring Yes) has skipped redemption of the bonds on the call date, or earlier. This indicates a safe track record for the product.
Still, AT-1 is the riskiest non-equity security that can be issued by a bank. But your advisor could showcase some AT-1 bonds that could be interesting investments.
