What are perpetual bonds or AT-1 bonds?

Kavya Balaji   /   March 16, 2020
perpetual bonds or AT-1 bonds

Additional Tier 1 bonds or AT-1 bonds are annual coupon bearing perpetual bonds. So, they have no fixed maturity date and bondholders get interest on the bonds. However, these bonds will have call dates, that is, they can be called back by the issuing bank. Typically, this is at the end of five years. Does this mean you will get back your money then? Not exactly.

Banks are under no legal obligation to exercise the call options. So, they can decide not to exercise the call option and not repay bondholders on the call dates. To understand these bonds better, you need to know why they were issued in the first place. So, how did these bonds come about?

The origin

After the 2008 financial crisis, the Basel-III accord introduced the AT-1 bonds. This was meant to protect depositors of a bank on a ‘going concern’ basis. The essential element of these bonds is the imposition of losses on the bondholders if the bank’s capital ratio falls below a threshold level. This could be done without having to liquidate the bank. Now, what is this capital ratio?

According to Basel-III norms, total regulatory capital for a bank consists of tier-1 capital and tier-2 capital. Tier-1 includes common equity tier-1 (CET1) and AT-1. Since 2014, minimum capital requirements have been gradually increased. Basel III norms say that the minimum tier-1 capital requirement for any bank needs to be 6% of the risk-weighted assets. This 6% will have 4.5% of CET1 and 1.5% of AT-1.

To maintain these ratios, banks started issuing AT-1 instruments. AT-1 instruments had a contractual provision that the AT-1 bonds can be written down if a bank needs to raise its capital levels or they could be converted into ordinary shares. This was to happen if CET ratio threshold is breached. It could also happen if authorities such as the Reserve Bank of India (RBI) find that the bank has reached the point of non-viability. 

What does AT-1 consist of?

AT-1 capital is made up of all the subordinated and perpetual tier-1 capital instruments issued by the bank that have not been included in CET1. It also has the share premium received from the issue of AT1 capital instruments. Any instruments issued by the bank’s subsidiaries and held by third parties will be included in the AT-1 capital too.

Basel III has actually defined 14 criteria for any instrument to qualify as an A-1 instrument. The criteria are different from that of CET1 as the AT-1 capital can be called after it has been issued. The bank cannot include any step-ups or incentives to redeem when they issue AT-1 bonds.

What do the AT-1 bonds offer?

As mentioned earlier, the bonds do not have a redemption date. They are callable at the initiative of the issuing bank only after a minimum period of five years. Supervisory approval is required for calling the bonds. The bank that issues these bonds has the full discretion to cancel coupon/dividend payments any time. So, the interest on these bonds isn’t guaranteed.

Coupon/dividends for these bonds have to be paid out of distributable surplus of the bank. The bondholders have to accept the losses on the bonds if the capital ratio falls below the threshold. The bonds will either be written down or converted to common shares. So, AT-1 bonds are quasi equity instruments that seek to protect bank depositors while leaving bondholders in high risk circumstances.

Then, why did mutual funds buy these bonds?

The answer is: yield. In comparison, AT-1 bonds across the globe offer over 5% yield while Indian AT-1 bonds offered yields of up to 12%. The yield for Indian PSU banks’ rupee perpetual bonds has been ranging between 8% and 12.5%in the past years. So, the higher yields lured mutual funds to invest in these bonds.

How have these bonds done globally?

Many years back, Banco Popular of Spain faced mounting losses. The European Commission, got the Spanish bank Santander to take over Banco Popular and imposed a write-down on AT-1 bond holders for close to 2 billion Euros. For Italian bank Montei Dei Paschi, 4.5 billion Euros worth AT-1 bonds were converted into ordinary shares.

In Europe, Basel-III doesn’t allow AT-1 bonds to be sold to individuals unless such investors have substantial wealth.

What about India?

Many banks have issued AT-1 bonds. However, it caught people’s attention only when Yes Bank got into difficulties. Yes Bank actually declined to exercise call options for its AT-1 bonds. It is estimated that the bank has issued AT-1 bonds worth Rs. 10,000 crores. Most of these bonds are held by institutional investors while a small portion is also held by individuals. RBI wrote down all the AT-1 bonds issued by the bank. Read how this will affect your mutual funds.

What’s the way forward?

Indian banks, especially private lenders, will find it difficult to sell AT-1 bonds in the coming years. Already, some banks have decided not to go ahead with the issues of these bonds. For instance, IndusInd Bank recently deferred its plans to sell AT-1 bonds.

The incident might have a broader impact on the banking industry. Industry experts feel that the yields of bonds issued by banks might go up as investors have now seen the clear extent of the risks these bonds have. Even though AT-1 is a riskier instrument when compared to a Tier-II bond, the market may not differentiate between them too much. There will be an increase in the risk premium for AT-1 bonds in the following years. Even those banks where the perceived risk is lower might need to sell the bonds at higher yields.