AT-1 bonds are back, but will they bring perpetual pain again?

Just a little over two years since Yes Bank’s bailout sprung a nasty surprise for investors of additional tier-1 (AT-1) bonds, these instruments are back as investor favourites.

For public sector banks, these bonds are a cost-effective way to raise capital, especially when the equity markets are unfriendly. Investors, on the other hand, need to be cautious.

India’s top two banks are in the market to raise about Rs 10,000 crore by issuing AT-1 bonds, or perps, as they are known in market lingo. HDFC Bank is looking to raise at least Rs 3,000 crore through such bonds, while the State Bank of India could go for a mop-up of Rs 5,000-6,000 crore.

Other lenders such as Canara Bank, Punjab National Bank, and Bank of Baroda are expected to scout for funds soon, after having already mopped up funds through perps in the past month.

The reason cited for this rush from banks to raise money is the rapid increase in credit growth. The banking sector’s loan growth surged to 15 percent as of mid-August from single digits just four months ago.

Lenders need capital to fulfill the demand for credit from the private sector. Capital can be raised through equity or debt. Regulations allow banks to have 1.5 percent of their risk-weighted assets in the form of AT-1 bonds within the overall tier-1 capital ratio of 7 percent.

Equity versus quasi-equity

Most lenders do not seem to have plans to raise capital through the equity market as investor sentiment is adverse globally right now. As such, raising equity is a long, expensive and cumbersome process, which leads to dilution.

For a bank to raise capital for lending, it would need to issue shares through a follow-on public offer. There is considerably uncertainty as to how a share issue would be received by investors.

For public sector banks, their largest shareholder, the government, will need to subscribe to any follow-on offer to avoid dilution of its stake. The Centre is unwilling to infuse more capital into lenders this year.

Further, depressed valuations make it difficult for lenders to raise capital from the market. Low valuations also mean greater dilution for the government, which again is a contentious issue.

Tier-I bonds seem the perfect instrument to avoid equity-like expenses and at the same time help in a quick fund-raising spree. They have a perpetual tenure, just as equity does, but a fixed return akin to a fixed-income instrument.

Given this quasi-equity-like structure, AT-1 bonds are very popular among investors.

“Investors’ desire for AT-I bonds of public banks has been bolstered by their improved financial position and improved ability to service them after setting off of their accumulated losses against their share premium account,” rating company ICRA said in an August 22 note.

Another selling point of these bonds is the call option by the issuing bank at the end of the fifth year and every year thereafter. Essentially, the issuer has the option to redeem the bonds early and give investors their money. This brings us to the biggest risk that these instruments pose for investors.

Risky bet

AT-I bonds cannot be compared with top-rated bonds issued by others simply because of the difference in tenure. Corporate bonds of all hues are for a specific term and the maturity period has a big bearing on how they are priced.

While the bank can call back the bonds at the end of the fifth year and every year thereafter, the discretion of early redemption lies with the issuer and not the investor. This is the main risk that investors are exposed to when they invest in these bonds.

It’s common to price these bonds as a five-year paper, keeping in mind the call option. In July, Canara Bank raised issued perpetual bonds at 8.24 percent, which was similar to the pricing of five-year corporate bonds issued by public sector entities. But perps are anything but a normal corporate bond. Bank of Baroda raised funds through such bonds at an even lower rate of 7.88 percent last week.

Yields on perps have drifted lower by 30-40 basis points over the past one month even though the nature of the bonds has been unchanged.

“There are no longer-term bonds being issued in the market so far but there is appetite. So investors are rushing to AT-1 bonds and short-term paper to put money,” said Venkatkrishnan Srinivasan, bond market veteran and founder of Rockfort Fincap.

It is pertinent to see whether banks have called back these bonds in the past. According to ICRA, outstanding AT-I bonds grew to Rs 1.01 lakh crore as of July from Rs 60,880 crore as of October 2020.

The rating company estimates that the issuance of such bonds in FY22 surged because banks refinanced redemptions. This shows that some banks called back their AT-1 bonds and issued new ones. To that extent, the pricing of the bonds as the five-year paper was appropriate.

Investors also believe that lenders would deliver on their promise to exercise the call option at the end of the fifth year.

“The experience with call options has been decent so far and there is a view that banks will have to deliver on their promise of calling back their bonds to maintain the trust of investors,” said a dealer.

In recent issuances, there was strong demand for perps from institutional investors and high net worth individuals (HNI). While institutional investors have the balance sheet strength and the bandwidth to do due diligence, HNIs lack these.

In the past, HNIs suffered big losses even on public sector bank AT-1 bonds. In the case of Yes Bank, their entire portfolio was written off.

While the fate of Yes Bank may not befall investors anymore, there is a need to price AT-1 bonds differently. After all, even regulators have mandated that mutual funds value these bonds as having 100-year maturity.