AT-1 Bonds: Watch out Before Subscribing | Nand L. Dhameja

AT-1 bonds are once again in news. This time for misselling issues and sharp sales practices. Over 97% of individual investors in the AT-1 bonds were existing customers of Yes Bank, and one-fifth of them prematurely closed their fixed deposits to invest in these bonds. It is alleged a large proportion of the investors were old customers with a low-risk appetite.

Issues of concern in such situation are:

• How far the principle, a golden rule, ‘let the buyer beware’, holds true in this case?
• Were the investors made aware of the risk involved? Were they informed about risk involved for their decision to invest in AT-1 bonds before taking the decision to invest?
• What is institutional role towards investors’ protection?

Before we discuss about the issues involved, let us discuss the meaning and features of AT-1 bonds.

AT-1 bonds or Additional Tier 1 bonds, also known as COCO (Contingent Convertible Bonds) in Europe are unsecured, perpetual bonds; these are normally issued by the banks to shore up their core capital base to meet the Basel-III norms; and are used as a saviour of banks. The issuance of AT-1 Bonds was first formulated after the 2008 financial crisis that saw the infamous fall of a banking behemoth ‘The Lehman Brothers’ in United States of America. In India the financial distress and liquidity crunch faced by the banks lead the Reserve Bank of India to formulate a plan in compliance with the BASEL-III Norms to make the financial institutions maintain a certain level of liquidity.

The Banks in India started issuing AT-1 Bonds which are perpetual bonds with no fixed maturity date. These are quasi-equity instruments regulated by the RBI; having higher interest rate with high risk, are suited to high-net-worth investors, mutual funds, insurance companies, or investment companies to have higher rate of return. These are in the form of fixed deposits or are of the nature of non-convertible bonds.

The bonds carry a call option of redeeming it after 5 or 10 though not compulsorily mandated. As such, are complex hybrid instruments, ideally meant for institutions and smart investors who can decipher their terms and assess if their higher rates compensate for their higher risks. In India, these bonds seem to have been sold to a fair number of retail investors as fixed deposit or NCD substitutes.

AT-1 bonds normally carry a face value of ₹10 lakh per bond are issued by banks through two routes, private placement by banks, or secondary market on the recommendations from brokers.

 AT-1 bonds are very different from plain-vanilla bonds and have unusual features namely,

• are perpetual, carry no maturity; however, they carry call options that banks can redeem them after five or ten years;
• interest payment could be skipped for a particular year
• face value of such bonds could be reduced or could be totally wiped off without the consent of investors subject to provisions of issue. Even AT-1 bonds could be written off in total by the RBI without consulting the investors.

About Rs 30,000 crore have been issued in such bonds by banks and mutual funds and represent about Rs. 80,000 crore of total invested in AT- bonds.

As a package to bailout YES bank which had issued AT 1 bonds, State Bank of India (SBI) came forward to have 49 % share capital and to infuse certain funds, another segment of investors required to have haircut was the AT -1 Bond holders and entire of their investment of Rs. 8,400 crore was to be wiped off.

In addition, the government notified a reconstruction scheme for Yes Bank, which among others, proposed a lock-in period of three years for certain equity shareholders and investments by SBI and three other private sector banks. The scheme, however, was silent on the treatment of AT-1 bonds.

It led to protests from certain quarters, even some took the matter to court, Mumbai High court, they included:

• certain high net worth investors, pensioners who had invested their entire retirement funds,
• trustees of bonds along with others aggrieved to take the haircut when even the YES Bank shareholders were better off,
• Trustee Services and India Bulls Housing Finance Ltd.
• a separate petition had also been filed by the L&T Officers and Supervisory Staff Provident Fund Trust.
  Bondholders and others had opposed the write-off and proposed a scheme which entailed a partial conversion of their bonds into equity.

In a separate stock exchange notification on March 14, 2020, however, Yes Bank’s RBI-appointed-administrator said AT-1 Bonds would have to be fully and permanently written down as the bank was deemed to have reached a point of non-viability and write-down was necessary before the reconstruction process.

As the data suggests that banks such as Societe Generale, Credit Suisse, Deutsche Bank, Royal Bank of Scotland had issued such bonds to the tune of $101 Billion from April, 2013 to early 2016. However, there were many speculations doing the rounds regarding the capacity of banks in different countries being able to service the AT-1 Bonds or the COCO Bonds. Even in the Middle-East countries, the AT-1 Bonds have been meted out with plenty of investments, for instance, Al Hilal Bank, from one of richest states i.e. Abu Dhabi received a good response after floating Additional Tier Bonds. Few banks in Europe tried to convert COCO Bonds into equity however, it was not met with feasible outcomes in the market. Globally, most international banks like, JP Morgan, HSBC, Standard Chartered Bank, Barclays, Citi Bank have issued AT-1 bonds and it is well accepted instrument to shore-up capital adequacy. During five months of 2020, 14 Chinese banks have raised perpetual bonds worth $ 40 billion.

In addition, banks which skipped interest payment or decided to write off perpetual bonds included:

• Bank of Jinzhou, last year, decided to skip the interest payment to its international bondholders after reporting losses in 2019.
• Banco Santander SA of Spain failed to redeem the issued bonds in February, 2019.
• The Arste Bank of Austria failed to stand up to their coupon payments for their COCO Bonds, though in 2016, it was able to pay an 8.875% coupon which was more than 2.5 times of what the bank was paying on the new issues.

In India Securities and Exchange Board of India (SEBI), the regulator issued a circular on March 15, 2021, capping debt mutual funds (MF) exposure to perpetual bonds, i.e., AT-1 bonds. It had also directed that MFs to use the 100-year valuation norms for pricing such bonds. The circular was to come into effect from April 1, 2021. The SEBI, it appears, had probably made this decision after the Reserve Bank of India (RBI) allowed a write-off of Rs 8,400 crore on AT-1 bonds issued by Yes Bank Ltd after the rescue package by the State Bank of India (SBI). In addition, there were representations on the regulator circular capping of debt mutual fund exposure to perpetual bonds (AT-1 Bonds)

Though, AT-1 bonds have emerged as the capital instrument of choice for state banks as they strive to shore up capital ratios. If there are restrictions on investments by mutual funds in such bonds, banks will find it tough to raise capital at a time when they need funds in the wake of soaring bad assets. A major chunk of AT1 bonds is bought by MFs, public sector banks have cumulatively raised around $2.3 billion in AT-1 instruments in 2020-21, amid a virtual absence of such issuance by private banks (barring one instance) in the aftermath of Yes Bank’s AT1 write-down in March 2020.

The Securities and Exchange Board of India (SEBI) recently relaxed the norms for valuation of perpetual bonds like, additional tier-1 (AT-1) bonds following strong objection from the government. The Finance Ministry had taken strong objection to SEBI’s proposal on valuation of perpetual bonds, which, as mentioned earlier, are primarily issued by public sector banks to meet their capital requirement under the Basel III regulations. The objection was also on the valuation norms for AT-1 bonds prescribed by the SEBI for mutual fund houses as it might lead to mutual funds making losses and exiting from these bonds, affecting capital raising plans of PSU banks; this was particularly so as the government had planned to privatise two government commercial banks. The norms relaxed by the regulator provided that the deemed residual maturity of Basel III additional tier-1 (AT-1) bonds will be 10 years until March 31, 2022. It will be increased to 20 and 30 years over the subsequent six-month period. And from April 2023 onwards, the residual maturity of AT-1 bonds will become 100 years from the date of issuance of the bond.

SEBI said that the new valuation methodology is based “on the representation of the MF industry to consider a glide path for implementation of the policy and request of other stakeholders†. It has further said that if the issuer does not exercise call option, then the valuation and calculation of duration shall be done considering maturity of 100 years from the date of issuance for AT-1 Bonds. Also, if the non-exercise of call option is due to the financial stress of the issuer or if there is any adverse news, the same shall be reflected in the valuation.

SEBI in its guidelines also mentioned that only qualified institutional buyers can participate in AT-1 bonds issue, with a minimum trading size of Rs. one crore, this is likely to ensure that retail investors are ring fenced.

Lastly, US debt markets are pretty deep with bonds with following features being traded in exchanges - secured or unsecured, fixed tenor, subordinate fixed tenor, perpetual bonds, zero coupon, high risk junk bonds, structured debt issuances etc. As compared to this Indian bond market is relatively shallower and with the objective, India to become a $5 trillion economy, issuance of more innovative financial products, like At-1 bonds would be required. SEBI focus should be not discouraging innovation or issuances; but ensure regulations around quality of disclosures, risk statements, quality of issuer and investors are well defined.

In view of the above and the norms by SEBI relating to AT-1 Bonds, issues of concern are:

• miss-selling and sharp sales practices of At-1 Bonds by Yes bank. As mentioned earlier, these bonds have been subscribed by individual investors by prematurely closely their fixed deposits; the customers were not made aware of the risks associated with the AT-1 bonds, as the application forms, including the documents pertaining to risk disclosures, were signed by customers at the settlement stage of the transactions, after they were already influenced to purchase the bonds.
• what was the role of the wealth team and the marketing strategy adopted by the wealth team; was there attractive incentive to market the AI-1 bonds to push the sales.
• are there adequate norms and measures towards investors’ protection? are the investors informed about the implications and consequences before taking decision to invest in AT bonds?
• above all, the golden rule, ‘Let the buyer beware’ holds true; and
  In short, in case you are approached by a relationship manager or a broker to buy a ‘bank bond’ offering a rather mouth-watering yield, check, are you being sold AT-1! 

7/6/21

(Author: Nand L. Dhameja, is Professor and Dean, Faculty of Management Studies, Manav Rachna International Institute of Research and Studies, Faridabad. The views expressed are personal of the author and not the organisation to which he belongs)