Joydeep Sen
We have seen a host of Bank Additional Tier I (AT1) Perpetual Bond Issuances since the changeover from Basel II to Basel III. The outstanding quantum of Bank AT1 bonds currently is Rs 39,000 crore for PSU Banks and another approximately Rs 6,800 crore of private sector Banks. AT1 bonds worth Rs 21,500 crore were issued in the current financial year. The acceptability of these bonds is increasing gradually as more financial institutions and HNIs are taking exposure.
To note certain facts, before we take the discussion ahead: Tier I Perpetual Bonds are quasi-equity as these have the equity-like features of (i) perpetual in nature (ii) high loss absorption capacity: there would be principal write-down or conversion to equity on breach of a trigger, which is equity capital ratio of 6.125% and (iii) discretionary pay-out with existence of full coupon discretion and high capital threshold for likely coupon non-payment. If core equity capital falls below 8%, likelihood of coupon non-payment increases significantly. Crisil rates AT1 perpetual bonds typically two notches below the corporate credit rating, due to these risks.
The increasing interest in the market about these perpetual bonds is more from the perspective of catching a higher yield. Search for higher yield increases in a falling interest rate scenario. To give a perspective, we can look at the yield in the secondary market for tax-free PSU bonds and gross it up for the ‘pre-tax equivalent’ to compare it with a taxable instrument. Taking the tax-free bond yield at say 6.1% and the tax rate at 30.9%, the pre-tax equivalent comes to 6.1% / (1-30.9%) = 8.83%. Since the perpetual bonds are rated lower than the AAA rated tax-free bonds and secondary market liquidity is lower, the yield should be accordingly higher. Since quite a few perpetual bonds are available at a relatively higher yield, some even in double digit yields, interest is getting generated among market participants.
The other contributing factor for investors’ increasing liking of the product is the perceived safety of a Bank being the issuer, more so for a PSU Bank, in that a Bank will not default, even if it is rated lower than AAA. Recently, IRDA has allowed insurance companies to take exposure to these bonds, adding another category of investors.
There is another avenue of taking exposure to the relatively higher yield and potential price appreciation of these bonds: there is a ‘structured’ debenture issued by an NBFC where the returns are linked to the movement of the underlying Bank AT1 bonds but the credit and liquidity risk is that of the issuing NBFC.
Given the complicated structure of perpetual bonds, they have been a wholesale offering. Brokers are willing to service high networth individuals with a condition of minimum investment of Rs 10 lakh in the secondary market.
The other relevant aspect of these bonds is that being perpetual there is no defined maturity date, but there are call options. Since there is no put option in these bonds, it will be interesting to watch whether and when the Issuers call these bonds as and when the call dates occur. In this context, we will discuss the buyback by Central Bank of India (CBI). CBI notified the Exchange on 23 January ’17 that they will buy back 9.4% perpetual bonds worth Rs 500 crore. To be noted, this is not an exercise of call option, which is otherwise due in September 2022, but a buyback. The nature of the instrument is Innovative Perpetual Debt Instrument, akin to AT1 bonds.
The fundamentals of the Bank are not in the best of conditions; after the launch of Asset Quality Review (AQR) by the RBI, many Banks have reported higher stressed assets. For CBI, in Q1FY17, gross NPA was 13.5% and net NPA was 8.17%. Total impaired assets, including restructured advances, were 19.27%. The Basel III ratios also are challenging: the Tier I Basel III capital adequacy ratio was 7.82% in Q1FY17 against the regulatory requirement of 7.625% on March ’16 and 8.25% on March ’17. The credit rating of the Perpetual Debt Instrument, which is being bought back, was downgraded by Brickwork Ratings to A+ with negative outlook from AA- in Sep ’16. Rating was BWR AA earlier. The buyback reportedly being at par, it is advisable to tender.
To form a perspective on the risk aspect of AT1 bonds, an earlier Crisil Press Release dated 12 Oct ’16 stated that “A sharp decline in profitability and mounting losses could wipe out the revenue reserves of some public sector banks (PSBs) and hamper their near-term ability to service coupon on AT1 Basel III bonds ... ... four PSBs have AT1 bonds outstanding where continued losses could wipe out their revenue reserves and pose a challenge when it comes to coupon servicing.”
Things have improved now; an RBI Circular dated 2 Feb ’17 states that for payment of coupon, if current year profits are not sufficient, coupon may be paid from brought forward profits, reserves as stipulated in the Circular net of accumulated losses and ultimately even statutory reserves. A Crisil release dated 3 February ’17 states “we estimate that the reserves available with PSBs to service coupon on AT1 bonds, under revised guidelines, is double from earlier and in case of weaker PSBs it has jumped by five times”.
The relevance of the CBI buyback from the risk perspective is one of interpretation: on one hand, they are under stress, being so close to the Basel III norms; on the other hand, they are being proactive in trying to manage a reputational risk issue by buying back. It also gives an implied comfort about other similar Issuers that when it comes to the crunch: Banks are likely to exercise the call option when it falls due.
To sum up, it is a calculated risk for the investors: earning a higher yield than that of a regular Bank bond and settling for a bond rated lower due to the risk features mentioned above.
The author is an independent financial advisor.
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