Time to bid adieu to AT1 bonds?

Investors should factor in the purpose and risks of such hybrid instruments and not get swayed by higher yields

The recent announcement by few public sector banks (PSBs) (with a few more expected to follow) to prematurely recall their additional tier 1 (AT1) bonds has elicited mixed reactions from various stakeholders. The move has obvious blessings from the Centre and the RBI as it helps avoid a coupon skip by PSBs, which could have added to the woes of the PSBs and hindered the Centre’s plan to get the economy back on track. One cannot but consider that an instrument that was supposed to absorb losses is the one that gets paid out first, defeating the main purpose for which it was introduced.

But a few investors are obviously happy as they would get back the invested principal in addition to the high coupon they enjoyed so far. However, many are not amused as they are likely to face capital loss, having invested in these papers at a premium to face value on perception of lower credit risk after seeing a few weak banks service these instruments, citing a different interpretation of the RBI guidelines.


Basel III norms were implemented in India from April 1, 2013 in a phased manner by the RBI, which required banks to maintain higher equity capital as well as higher overall capital levels. Unlike Basel II capital instruments, Basel III capital instruments have loss absorption features. AT1 instruments, which form part of the Tier 1 capital, are designed to absorb losses as they could be written down or converted to equity before the injection of public money to bail-out the financial institutions when their capitalisation levels go below a certain threshold.

While the initial investor response to these instruments was lukewarm, the RBI amended the guidelines in September 2014 to make it more attractive to investors. First, the call option date was reduced to five from ten years. Two, the coupon could be serviced from accumulated profits of the bank as compared to servicing the coupon from the current year’s profits.

In line with expectations, the risk perception on these instruments declined and with better investor appetite, PSBs issued AT1 aggregating ₹13,500 crore during FY2015 as against nil during FY2014. The average coupon on these bonds of around 10.4 per cent was well above the comparable G-sec yield of 8.5 per cent prevalent then, given the risk absorption nature of these instruments.

Upon the commencement of asset quality review exercise by the RBI during H2FY2016 and consequent recognition of stressed assets, the losses of public sector banks (PSBs) surged to ₹18,000 crore during FY2016 (profit of ₹37,500 crore in FY2015) as credit costs increased. Despite the lower loss of ₹4,230 crore in FY2017 on the back of sizeable treasury gains, limited capital allocation under the Indradhanush plan of the Centre and their inability to raise external equity capital, PSBs cumulatively raised ₹35,935 crore AT1 during FY2016 and FY2017. This was aided by adequate systemic liquidity and increasing investor risk appetite.

While the investors enjoyed a good spread on these instruments over the risk-free rates, their belief that the regulator or the Centre would ensure that PSBs would not skip coupon on AT1 bonds was reinforced by the further regulatory relaxation. The criteria for servicing the coupon were relaxed.

Besides, the Centre also did a last-minute capital infusion in one PSB during August 2017 to enable the bank to improve capital ratio, an important factor to service the AT1 bonds. Consequently, PSBs raised additional AT1, aggregating ₹10,900 crore during 9MFY2018 despite modest credit growth. The grand PSB recapitalisation programme announcement in October 2017 provided further fillip to the AT1 market as the secondary market volumes rose and yields declined sharply on such papers.

Ground reality

Expecting continued sovereign support, many investors continued to overlook the fact that the risk of coupon skip on AT1 had increased during FY2018 as PSBs’ distributable reserves got depleted and reported loss of ₹22,500 crore during September FY2018 on the back of higher credit provisions and marked-to-market losses on investments portfolio.

Amid all these events, the Centre’s recent instruction prohibiting PSBs from issuing further AT1 without its consent and the RBI clarification that the inclusion of a bank under PCA can be termed as a “regulatory event” reiterate the risky nature of these instruments. Preferring to fall short on capital ratios as compared to skipping a coupon on AT1 instruments, a few PSBs have used the opportunity and announced an early recall on the AT1 instruments, an event that investors clearly did not factor in.

For the development of this market, it is important that all stakeholders understand the risks and purpose of such hybrid instruments. With changing regulations, investors should factor in the stated purpose and the associated risks of such hybrid instruments without getting swayed by higher yields. Investors may be better off avoiding these instruments.

The writer is senior Vice-President and Group Head - Financial Sector Ratings, ICRA

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