We discussed earlier, the debacle in Yes Bank additional tier 1 (AT1) perpetual bonds, how they were mis-sold to investors who are not savvy, and the matter being in the court of law now. In light of this unfortunate episode, let us now take another look. The reason is, in behavioural finance, there is a concept of recency bias, which means people give higher weightage to events in the recent past. Till Yes Bank AT1 default, the recency bias was positive as there was no default in this category of bonds. Now the bias is negative, fresh from the memories of Yes Bank. The important thing is, we should learn from these events, and develop the right perspective. The bad episode is an eye opener on the risks involved in AT1 bonds.
risks and caveats
The bonds face two major risks: coupon discretion and loss absorption. Coupon discretion means the banks issuing the AT1 bonds can service the interest due only if they are making profit or have adequate balance in certain defined reserves. The risk of loss absorption is well-known by now. Usually, bondholders would get preference over equity holders when it comes to the crunch. However, that works during liquidation. If the bank is not going into liquidation, like in the case of Yes Bank, AT1 bondholders may not get any preference over equity shareholders.
The other caveats are maturity and eligibility for retail investors. On paper, these are perpetual bonds, but there is a call option five years from the date of issuance and every anniversary thereafter. Though call option is taken at the discretion of the issuer, the market assumes that the option would be exercised, otherwise the bonds of that issuer would be priced adversely in the market. On eligibility, since most of these bonds were issued through private placement, retail investors are not mentioned under the “who can apply” clause of the information memorandum (IM) and the face value is mostly ₹10 lakh. Individuals can purchase from the secondary market, but that becomes a grey area if individuals are not eligible.
In spite of the risks emanating from the covid-19-related slowdown, the banking sector remains reasonably strong. This sector is a pillar of the economic structure of the country. There is a case for investment in AT1 perpetual bonds, with a proper understanding of the risks mentioned above. Here is the investment rationale.
The yield (annualized return) of the bond in the secondary market tells you the story. The lower the yield, lower is the risk. In the institutional market comprising of banks, insurance companies, large corporate treasuries and mutual funds, among others, analysts assess the risk. If the risk perception is higher, the market would ask for a higher yield.
No AT1 perpetual bond is rated AAA, due to the risks mentioned above. AT1 bonds of the best of banks is rated AA+. The credit rating will give you a perspective.
In PSU banks, with a majority holding of the government, though it is not a stated guarantee, there is an implied safety. So, in case of a crunch, the government would step in. We saw this in the case of IDBI Bank, which was “given” to LIC. In private sector banks, look at the fundamental quality. If the yield is reasonably low compared to other similar bonds on offer, it implies that risk is proportionately lower. Credit rating is another parameter.
Who should invest?
If you are an individual investor such as a high net-worth individual (HNI) or a mass affluent individual and do not have the analytical bandwidth of an institutional investor, you need to be extra careful about the risks and eligibility. Term deposits and AT1 perpetual bonds are not comparable from the risk perspective, something to which the Yes Bank debacle has opened our eyes. Deposits were bailed out as other leading banks were “requested” to take a stake in Yes Bank. It is a sales pitch that FD of a bank would give you X% and AT1 bond of the same bank will give you Y%. Currently, the AT1 bond of a private sector bank is trading at a very high yield of approximately 17%. It looks attractive, may be it is an over-reaction of the market on the risk assessment. However, it is better left for institutional buyers. Only savvy individuals should look at AT1 bonds of marquee PSU and private sector banks.