AT-1 bond returns are attractive compared to FDs, but factor in the risks

Their spread over G-Secs of comparable maturity have also declined compared to historical averages

Additional tier 1 (AT1) bonds, which the market had shunned after the YES Bank debacle, are once again gaining popularity. Seven banks have raised ~18,376 crore through these bonds since July at yields ranging between 7.75 per cent and 8.75 per cent.

Many high networth individuals (HNIs), too, are gravitating towards them since these rates are much higher than State Bank of India’s (SBI’s) fixed deposit (FD) rate of 5.65 per cent (6.45 per cent for senior citizens) for a 5–10-year tenure.

Quasi-equity features

To lend more, banks need to shore up their equity capital. However, they don’t like to issue additional equity. Doing so dilutes their return on equity. Instead, they issue AT1 bonds, which they can treat as equity for calculating their tier 1 capital.

According to Ankit Gupta, founder, BondsIndia, “Investors don’t get the benefit of equity in these instruments as their value doesn’t grow the way the value of shares grows. Instead, they offer a fixed rate of return. They also carry higher risk. If the bank faces too many defaults, their value could get written off to zero.”  

After the YES Bank fiasco, the Securities and Exchange Board of India (Sebi) curtailed retail participation by increasing their face value to ~1 crore.

HNIs invest by purchasing them in the secondary market from bond distributors.

Loss absorption risk

The key risk of AT1 bonds arises from a feature called loss absorption. When a bank is being restructured or liquidated, the order of repayment is as follows: FD holders, and then secured debt, unsecured or subordinate debt, and perpetual debt (AT1 bond) holders.

“These bonds rank last in repayment — just before equity — which makes them the riskiest among fixed-income securities,” says Gupta.

According to Joydeep Sen, corporate trainer (debt markets) and author, “What the YES Bank fiasco also revealed is that AT1 bond investors can suffer loss — not just if the bank goes bankrupt and shuts down, but even if it remains a going concern.”

The aforementioned risk reduces in the case of banks having stronger fundamentals.

“However, compared to the normal bonds of the same bank, AT1 bonds would be riskier, which is why they offer a higher rate of return,” says Gupta.  

Another risk arises from ‘coupon discretion’.

“In the case of AT1 bonds, the payment of the coupon depends on whether the bank has profits. It can also dip into its reserves to pay coupons. In normal bonds and debentures, payment of coupon is not contingent on whether the issuer is in profit or loss. Non-payment of coupon hasn’t happened to date in AT1 bonds, but the risk exists,” says Sen.

AT1 bonds come with a call option. The issuer bank can recall them after five years (or subsequently on the anniversary of issuance). Usually, these bonds get recalled on the first call date (that is, five years after issuance).

According to Deepesh Raghaw, founder, PersonalFinancePlan, a Sebi-registered investment advisor, “If the bank exercises its call option when interest rates are going down, that subjects the investor to reinvestment risk.”

How to make the right choice  

While selecting an AT1 bond, take into account the bank’s credit rating, the size of its balance sheet, and its corporate governance standards.

You can use a simple method for selection. Each bond house has an inventory sheet where all bonds and their yields are listed.

“Top tier banks like SBI, HDFC offer the lowest yield. Those whose fundamentals are perceived to be not as good offer higher yields. Select a bank whose risk level you are comfortable with,” advises Sen.

Should you invest?

The YES Bank mess should not deter investors from investing in AT1 bonds of higher-quality banks. However, before they do so, they should check whether they are being compensated adequately. Compare the yields of government securities (G-Secs) with the yields of AT1 bonds having a similar call date profile.

“The spread between G-Sec yields and callable AT1 bonds yields was higher earlier. Spreads have narrowed now. Hence, investors need to decide whether to buy now or defer the purchase until the spreads become more reasonable,” says Sen.

Investors not familiar with the risks of these bonds should avoid them. Senior citizens should stay away entirely.

CONSIDER THESE ALTERNATIVES

• Senior citizens should consider products such as Prime Minister Vaya Vandana Yojana and Senior Citizens Savings Scheme, which offer 7.4% each
• Another safe alternative is the RBI Floating Rate Savings Bond which offers 7.15% 
• Consider whether the extra potential risk in AT1 bonds (even from high quality banks) is worth taking for the 35-70-basis point of extra return
• Investors may also consider target maturity funds maturing in 2027 offering yield-to-maturity of 7.2-7.3%, and come with indexation benefit