What’s leading to mispricing of AT1 bonds?

Conditional coupon clauses with complex product structure keep investors on edge

Not too long ago, some exempted provident funds (PFs) and corporates invested in Basel III Tier 1 bonds (also known as Additional Tier 1, or AT1 bonds) at far higher prices — or lower spreads over government securities — than what the market could have offered.

What caused the mispricing?

They perhaps feared two things: a faster fall in interest rates, and higher annual interest payments to subscribers which, in turn, led to a yield hunt.

Not surprisingly, secondary market activity in AT1 bonds has been high, with traded volume rocketing 45 per cent in calendar 2016 to touch ₹32,000 crore. The trend continued in the first quarter of calendar 2017. Even so, there is no clear price discovery trend.

It has been more than three years since the first such bond was launched by Bank of India at a spread of 192 basis points over the 10-year benchmark G-Sec. The bond offered a coupon of 11 per cent and was rated AAA initially, but later downgraded to AA+ and then to AA-.

Initial regulations were stringent, which discouraged investors and there were no issuances for almost a year. The Reserve Bank of India (RBI) then changed the rules and permitted temporary write-downs and 5-year call options, and mandated that coupon payments must be made only from revenue reserves and not current year’s profit.

That made the bonds more attractive and, not surprisingly, there were nearly 40 issuances of these quasi-equity structures, largely by public sector banks (some private ones also borrowed through this route).

There is a fixed coupon on these bonds, but it’s not as simple as it sounds because coupon payment is bound by caveats, and so is the principal payment in some cases. However, on February 2, 2017, the RBI broadened the scope of available reserves to service coupon, which lowered the risk on the bonds to some extent. But conditional and discretionary coupon payment terms remain, which left investors vulnerable.

Also, pricing uncertainty is common for new and complex products. Between September 2014, when issuances gained currency, and March 2015, there was a huge swing in spreads. After dropping in January and February 2015, spreads rebounded in March.

In 2015 and 2016, bonds worth ₹9,800 crore and ₹17,750 crore were issued, respectively, and trading soared from ₹22,000 crore in 2015 to ₹32,600 crore in 2016.

Pricing history

Primary issuances are a good indicator of pricing when done in large quantities and involve multiple types of investors. The accompanying table suggests that over the last three years, spreads have risen for Basel III Tier I bonds over the benchmark G-Sec yield curve, indicating investors found the instrument to be increasingly risky.

An analysis of CRISIL’s Security Level Valuations (SLV) suggests that over 50 per cent of the trades reported during this period were outliers (where spreads deviate by 10-30 bps or more from the SLV). Secondly, the mispricing — or the difference between transacted spread and the average spread of CRISIL SLV — swung in a very wide band of negative 1.86 per cent to positive 0.05 per cent.

Negative spreads indicate that investors are earning lesser spreads (compared with the prevailing fair pricing based on CRISIL SLV), while positive spreads mean the opposite.

CRISIL believes that active investors such as mutual funds and insurance players, to a great extent, keep a close watch on spreads and credit actions to ensure a good bargain. However, investors such as provident funds, which are required to meet the mandatory payout declared (the interest rate for fiscal 2017 is 8.65 per cent) by the Employees Provident Fund Organisation, tend to look for debt securities with additional yield kicker. Corporates, too, in order to achieve wealth maximisation on dormant treasury book, often prefer to invest in AT1 bonds.

However, investors in these bonds need to be aware of this anomaly in spreads in the secondary market and look more closely at the risk-adjusted return so that they don’t end up on the wrong side of yields when trying to meet the benchmark return or earn a yield kicker.

The writer is Senior Director, Funds & Fixed Income, CRISIL Research

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