What are AT1 bonds? How are they different from conventional corporate bonds?
AT1 bonds, short for Additional Tier 1 bonds, are a class of bonds issued by banks. After the 2007-08 global financial crisis, it was felt that banks should operate with a higher proportion of their own permanent capital rather than borrowed capital. This permanent capital is called Tier 1 capital.
Now, to shore up their Tier 1 capital, banks have been allowed to raise a special class of bonds known as AT1 bonds from investors. AT1 bonds, like other bonds, pay regular interest. But they do not have an expiration date, since they are a permanent part of the bank’s capital, similar to equity.
In practice, however, banks offer a call option on these bonds after 5 years, when they may or may not redeem them. Aside from not having a maturity date, AT1 bonds are also different from vanilla bonds in other ways.
The issuing bank has the discretion to reduce or skip interest payments entirely if it is running a loss or risks not meeting capital needs. If RBI believes the bank is running out of capital or is unviable to operate, it can order the principal on these bonds to be written off as well. This makes AT1 bonds much riskier than standard corporate bonds.
What is the Yes Bank AT1 bond issue about?
Yes Bank experienced a significant increase in its non-performing assets and reduced deposits between September 2019 and March 2020. RBI decided to step in before finances worsened further. It placed restrictions on depositors to withdraw their money from March 5, 2020, and appointed an administrator. SBI was hired to infuse capital into the bank while a rebuilding package was designed. This rebuilding scheme required Yes Bank creditors to cut their hair. RBI decided that the bank’s AT1 bond obligations would be permanently cancelled.
But this cancellation surprised some of the investors in Yes Bank’s AT1 bonds.
They complained that when Yes Bank staff sold them these AT1 bonds, they were not informed about their coupon or principal amortization characteristics. Nor did they know that these ties were perpetual. They clearly did not read the information memo mentioning these risk factors.
SEBI investigations found that Yes Bank officials were guilty of inappropriately selling these bonds to unsuitable investors, such as senior citizens, and that institutional investors offloaded their bonds to retail clients. Approved orders and imposed sanctions on Yes Bank’s top executives. But investors in the bonds also rallied to challenge the cancellation decision in court. Last week, the Bombay High Court approved an order to stay the cancellation of Yes Bank’s AT1 bonds on technical grounds. It is not yet clear if Yes Bank will appeal this decision.
Will Yes Bank’s finances be affected if the Bombay High Court order is implemented?
Not very materially. The court order essentially requires Yes Bank to restore Tier 1 bonds valued at more than ₹8,300 crore on its books, while making a principal write-off. This would effectively mean that the bank’s equity capital would take a hit of around 3 percent, which would be offset if the Tier 1 bonds are reinstated. If Yes Bank decides to call the bonds, its Tier 1 capital may take a 3 percent dent. percent, which you will have to offset through a new Tier 1 bond or stock issue. There is also the possibility that Tier 1 bondholders could convert their holdings into Yes Bank shares, in which case there will be no impact.
Are these AT1 bonds safe for investors? What category of investors should invest in them?
Since RBI and banks enjoy complete discretion to skip interest payments, defer the call option or cancel the principal on AT1 bonds, they are totally unsuitable for retail investors.
After the Yes Bank fiasco, SEBI had ruled that AT1 bonds should be sold only in minimum tickets of ₹1 crore and above, to institutional investors. But the older tranches of AT1 bonds continue to trade in lower lot sizes of ₹10 lakhs in the market. Brokers offer them to individual investors, as “high-yield” FD substitutes. Only investors willing to take the risk of capital loss with a high enough net worth to invest such a large sum should consider them.
