After Sebi’s Ruling, Can Individuals Directly Hold AT1 Bonds? 

The market regulator’s AT1 and Tier-II bonds ruling may have made it tougher for mutual funds to hold them, but it doesn’t stop individual investors from putting in their money there. The ruling, though, has underscored the risk levels, but not all AT1 bonds are a throwaway.

Discussions on the suitability of a bank’s Additional Tier 1 Perpetual Bonds (AT1 perps) for individual investors, is by no means new.

The context for re-initiating the discussion is a recent event, which does not alter in a material way (apart from cost of raising capital moving up to an extent), the fundamental quality of Banks issuing AT1 perpetuals.

The event is that the norms for valuation of AT1 perps in mutual fund (MF) portfolios for computation of net asset value (NAV) and portfolio maturity, have been changed. This makes the instrument, and consequently the portfolios holding these, more volatile.

For other investors – insurance companies, banks (as investors), individuals and corporate treasuries, among others – there is no obligation to follow the new norms as the SEBI Circular is addressed only to mutual funds.

The yield, i.e. the effective annualized return available on the purchase of these bonds, have moved up as MFs have turned sellers.

This makes it an attractive proposition to buy. But importantly, from the perspective of individual investors, the risk factors and other relevant aspects become focus areas of interest.

Credit quality risk

The risk factors of AT1 perps, which are quasi-equity-quasi-debt, always existed, but did not get under the skin of the people.

Now, after the two credit events, people are increasingly aware of the risks. In case of Yes Bank, AT1 bonds were written off to the extent of Rs 8,415 crore while equity stock was not touched. These bonds can be written off to absorb losses, along with or without equity of the bank.

In the case of Lakshmi Vilas Bank (LVB), Tier II Bonds under Basel III norms (the framework under which these Tier I and Tier II bonds are issued) worth approximately Rs 318 crore was written off, along with equity.

Having spoken of the risks, it would be worth concentrating on the investment argument. While these two events have taken place, it would be unfair to tar all the banks with the same brush.

There are marquee banks like the State Bank of India or HDFC Bank, which will not operate using this route. While investing in equity shares of SBI or HDFC or other better-quality banks, there are concerns about the upside in stock price, but surely, there is certainty that they will not go the way of YES Bank or Lakshmi Vilas Bank Ltd.

The issuer is the same, be it equity stocks or AT1 bonds. An individual can pick up his or her bank as per analysis and risk appetite; not as an `enhanced-fixed-deposit’, but for the higher yield over regular bonds of the same bank, acutely aware of the risk factors.

Minimum lot size

A SEBI Circular dated 6 October 2020, effective 12 October 2020, states that for forthcoming issuances of AT1 bonds, only qualified institutional buyers (QIBs) are eligible to buy in the primary issuance and minimum lot size shall be Rs 1 crore.

In the secondary market, all investors, including non-QIBs, are eligible and the lot size shall be minimum of Rs 1 crore.

The implication for existing AT1 perps, outstanding as on 12 October 2020, is that all investors are eligible, including individuals, and there is no stipulation of a minimum trading lot size.

Can individual investors invest in AT1 bonds?

The Information Memorandum (IM) of a bond primary issue, colloquially referred to as the Offer Document, includes a clause on `Who can apply’, which is essentially the list of eligible investors.

In the bond market, which is wholesale or institutional in nature, most of the primary issuances come through the private placement route. For private placements, Section 42 of Companies Act states that the maximum number of persons to which allotment can be made shall not exceed 200 (excluding QIBs) in a financial year. Hence in many cases, the IMs of bonds that were initiated through private placement does not include individuals as eligible.

As a market practice, in the secondary market, individuals do trade in such bonds where the IM does not include individuals in the `Who can apply’ clause and these deals are settled through the Exchanges, the NSE and the BSE.

All investors in AT1 bonds, including individuals, get their coupon (interest) from the issuing bank, irrespective of whether the IM includes individuals as eligible. The implication is this: the IM is more relevant for the primary market than secondary. However, to be sure, individual investors can check the IM to see who are eligible to invest.

What does RBI think of AT1 bonds?

RBI has generally supported AT1 bonds; a central bank circular dated 2 February 2017 states that for payment of coupon, if current year profits are not sufficient, coupon may be paid from brought forward profits and reserves, as stipulated in the circular net of accumulated losses and ultimately even statutory reserves.

The premature call-back of AT1 bonds by 11 public sector unit (PSU) banks under Prompt Corrective Action (PCA) in 2018, is another case in point. However, in case of Yes Bank and LVB, the RBI took a stricter stance.

End note

Any investment carries risks, except government securities. In AT1 perps, if you are aware of the risks and other relevant aspects, you can take a calculated bet on the better-quality banks for the relatively higher yield.


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