No bank has AAA rating for these instruments
Ever since the default in AT1 (additional tier 1) perpetual bonds of Yes Bank, there has been lot of discussion on the risks of this instrument which was hitherto not understood or communicated. Here are some facts about AT1 bonds and how HNI investors can choose from among the available bonds for investment.
Risks
To recap, unlike in other bonds, there are two major risks in bank AT1 perpetual bonds. One, coupon discretion – the coupon or interest payable on these bonds can be serviced only if the bank is earning profits, or from certain permissible reserves.
That is, if a bank is loss-making or does not have adequate reserves, your coupon may not be paid. Two, loss absorption. The stark reality of this hit us in case of Yes Bank where the entire outstanding quantum of ₹8,415 crore was written off.
In this sense, bank AT1 perpetual bonds are similar to equity, that is if an issuer gets liquidated, the holders of the instrument have to participate in the loss. The additional learning in the case was that these instruments can be struck down even without touching the equity shareholders of the bank.
Apart from this, there is the issue of mis-selling too. In many cases, these instruments were sold as ‘similar to fixed deposits’ – buy into AT1 bonds of the same bank for higher returns. Returns are higher due to the risk factors and this needs to be understood.
Implicit safeguards
What then is the case for investment? Is it only the incremental return over the regular bonds issued by the same bank? No. There is also comfort from the fact that public sector banks have the implicit support of the Centre. This is not a stated guarantee like the ₹5 lakh insurance cover for bank deposits under Deposit Insurance Credit Guarantee Corporation (DICGC). However, this is a premise on which the bond market works which is not expected to be transgressed. There are instances of this implied support – when the AT1 bonds of certain loss making PSU banks were facing uncertainty, the regulator arranged premature call-back by all such banks. Apart from PSU banks, there are leading private sector banks too with sound fundamentals. Despite the write-down of AT1 bonds of one private sector bank, we cannot tar every bank with the same brush. While these bonds are perpetual, there is a call option at 5 years from issuance date and every anniversary thereof. Though it is only a call option and not a compulsion, bond market expects the call option will be exercised by the issuer and so far, call options have been honoured.
Suitability
On October 6, 2020, SEBI notified that for primary issuances of bank AT1 perpetual bonds after October 12, 2020, only Qualified Institutional Buyers are allowed and the allotment size and trading lot size shall be ₹1 crore. Individuals can purchase these AT1 bonds only from the secondary market but only in lot sizes of ₹1 crore.
However, for earlier AT1 bond issuances (prior to October 12, 2020), individuals can buy in lot sizes of less than ₹1 crore subject to the bond face value. For example, if the face value of one bond is ₹10 lakh, investment / trading can happen in multiples of ₹10 lakh. For buying AT1 bonds, investors have to approach wealth management firms and bond houses specializing in these bonds.
So, if you are an HNI investor, how do you choose from among the AT1 perpetual bonds available ? You can take the credit rating as one parameter to narrow down the choice. No bank has AAA rating for these instruments, due to the risks mentioned.
The highest credit rating assigned is AA+. In the public sector, AT1 bonds of State Bank of India and Bank of Baroda, and in the private sector, those of HDFC, ICICI and Axis have a AA+ rating. The returns can be another parameter.
Since there is no maturity, it is not yield-to-maturity (YTM) but the yield-to-call (YTC). Broadly, the YTC of AT1 perpetual bonds of these banks with a call option two to three years away, ranges from 6.25 per cent to 6.5 per cent and for those with five years to call, ranges from 7.35 per cent to 7.60 per cent in the secondary market.