As part of the restructuring plan for Yes Bank, the RBI announced that the instruments qualifying as additional tier-1 capital (AT1), issued by Yes Bank under Basel-III framework, shall stand written down permanently, in full, with effect from the appointed date. This is for the first time in the history of the Indian banking sector that a bank’s T1 bonds are being written down at the ‘point of non-viability’ (PONV) i.e. the investors have to take a hit on both principal and the balance interest payments. The AT1 bond holders have bets totaling to Rs.10,800 cr on the lender.
Under Basel III, banks will be required to hold at least 6% of their risk-weighted assets (RWA) in the form of Tier 1 capital. Of that, up to one fourth of Tier 1 capital may be in the form of “Additional Tier 1 Capital”.
For qualifying as AT1, the debt capital instrument must have the following terms
- Claim of investors is junior to depositors, general creditors and subordinated Tier 2 debt holders
- Perpetual, with no fixed maturity date, no put option
- Callable not before 5 years, callable later with regulator consent
- Coupon to be paid only out of distributable items; cancellation of payment at the sole discretion of the bank without any penalty or event of default; coupon not paid is non-cumulative in nature
- Converts into ordinary shares or has its principal amount written down at a pre-specified trigger point (going concern trigger); at a point of non-viability of the bank (gone concern trigger)
Thus these instruments are contingent convertible and come with equity-like loss-absorption features. If an issuing bank incurs losses in a financial year, it cannot make coupon payment to its bondholders even if it has enough liquidity. This means higher levels of loss-severity and higher probability of default when compared to conventional debt instruments.
Although as per Basel III the minimum capital ratio that is to be maintained is 8% of RWA, RBI asks Indian Scheduled Commercial Banks to maintain 9% total capital ratio. Of this, AT1 can be admitted maximum upto 1.5% of RWAs. If the equity capital of the issuer falls below 6.125%, the entire investment of AT1 bondholders would be either written down or converted to equity.
These issuances started in 2014 when Brickworks Ratings assigned a rating of AAA to the AT1 bonds of Bank of India (BoI). The market was surprised with the highest possible rating awarded for AT1 and the same rating as that of BoI’s senior credit rating. On the other hand, global rating agencies typically rate AT1 bonds four notches below bank’s senior credit rating to signal the potential risks in these bonds.
In September 2014 RBI relaxed the terms on AT1 instruments (can have a call option after 5 years) and even permitted banks to issue these instruments to retail investors.
Rating agencies often reason “majority ownership of Government of India and likelihood of strong support from the government on an ongoing basis” as the primary reason for these high ratings for AT1 bonds of PSBs in India. There is a strong belief that the government would bail out PSBs if they are in trouble. This kills the very purpose of Basel III bonds. The Basel III bonds were designed to limit injection of public money in stressed banks.Compare this with global standards, where instruments are rated in the single ‘B’ range.
When compared to AT1 issuances by banks globally, Indian banks have enjoyed very low spreads over their Tier 2 bonds or even over government securities. The coupon spreads in India generally range form 30-50 bps between tier 2 AT1 bonds of the same bank, though there is a marked difference in risk. Whereas Bank of International Settlements reports this spread for banks to be at least 250 bps on an average. Has the Indian bond market been pricing these bonds aggressively? Maybe the Yes Bank saga is a good wakeup call for all of us.
Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 12 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata. He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’