Banks have a number of ways to raise money for their institution – some of which are used in their day-to-day operations and some to build up the reserves as required by the relevant regulations.
To do the latter, the banks can either raise equity, debt, or some combination of both.
One of the debt-related instruments issued by the banks to increase their equity base is AT1 bonds. Sounds funny right? How can you increase your ‘equity’ by issuing ‘debt’ or bonds? Let’s find out.
What are AT1 bonds?
Additional Tier 1 bonds or AT1 bonds, fall in the category of perpetual bonds, and by definition have no maturity date i.e perpetual. AT1 bonds are issued by banks primarily to increase their core equity base and comply with the baseline requirements of the Basel III norms. Basel III is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2008.
The Basel III norms dictate that banks must maintain a capital adequacy ratio (CAR) of at least 8%. However, in India, Reserve Bank of India (RBI) norms mandate that India’s PSU banks like SBI, PNB, etc maintain a CAR of 12% and other private scheduled commercial banks maintain a CAR of 9%. The capital Adequacy Ratio is a measure of a bank’s risk capital.
AT1 bonds offer higher returns with higher risk, most of it sourced from its perpetual nature – no maturity. Banks are not expected to pay back the principal amount, but they carry the right and not an obligation to return the principal after exercising a call option. Call options offer its holder an option to buy a financial instrument at a pre-determined price.
Why do banks issue them?
As mentioned above, the primary reason for the banks to issue AT1 bonds is to increase the core equity base with the funds raised which is done periodically. The AT1 bond market took a massive hit in 2020 pegged by RBI allowing the write-off of AT1 bonds issued by Yes Bank worth Rs. 8,414 Cr during its reconstruction. But, investors are more confident about banking institutions with experts seeing issuances topping Rs 30,000 crore this financial year.
Features of AT1 bonds
Maturity: With no maturity period, AT1 bond issuers are not expected to return the principal amount. And hence they usually have no maturity date. Banks however do hold a call option if they do want to exercise their right to buy back the bond at a pre-determined price.
Return: Interest rates offered on AT1 bonds are usually higher than other debt instruments like NCDs, and FDs offered by the same back. This is because these instruments are unsecured and can be written off by the bank during periods of extreme stress. To compensate investors for the additional risk, banks offer a higher rate of interest.
Security: Banking institutions have the ability to write off these bonds which makes them the riskiest when the bank is under any constraints (as happened in the Yes Bank’s case).
Trade: These bonds can be traded on the stock exchange as well as sold in secondary markets.
SEBI’s AT1 regulation for Mutual Fund houses
As per the recent directive from SEBI, mutual fund companies must value these AT1 bonds as 100-year instruments. This will have a significant impact on the fund’s NAV should there be a fall in the value/price of the bond due to an increase in the interest rate (Bond prices and the direction of interest rates are inversely related).
Moreover, to limit the exposure that fund houses can have – they are mandated to have not more than 10% of the total assets invested in these AT1 bonds given their high-risk and long-dated nature. Therefore, as an investor before investing in any debt fund – it’s always good to have an understanding of their exposure to these bonds and ascertain the risk nature.
Why are AT1 bonds perpetual?
- AT1 bonds have no maturity date, i.e the investor doesn’t have the option to redeem the bonds and only the bank has the call option after a certain period of time.
Who regulates AT1 bonds?
- The Securities and Exchange Board of India (SEBI) regulates AT1 bonds in line with Basel III guidelines.
Should I invest in AT1 bonds?
- From April 2023, SEBI has directed to increase the maturity of these AT1 bonds to 100 years. And therefore, you should stick to big brand names and have very limited exposure to these bonds as part of your debt allocation in your overall portfolio due to the high-risk nature of these financial instruments.