What are AT-1 Bonds?

Additional Tier-1 bonds, aka AT-1 bonds are a type of unsecured, perpetual bonds that banks issue to shore up their core capital base to meet the Basel-III norms.

Characteristics:

AT-1 bonds have several unusual characteristics, which differentiate them from plain-vanilla bonds.

1. These bonds are attached with a call option, meaning banks can redeem them after 5 or 10 years from the issue date. But redeeming them is in bank’s discretion. Banks may not use the feature and continue to pay interest on them for eternity.

2. Banks can even skip paying interest on these bonds or reduce bond’s face value in case their capital ratios fall below certain thresholds. These limits are mentioned in the offer terms.

3. If the central bank feels that a particular bank is not in a good financial state and needs help, it can ask the bank to cancel its outstanding AT-1 bonds without even consulting with the holders. This is what happened in Yes Bank’s case, a year ago.

4. Bondholder do have an option to exit their position in a perpetual bond by selling in secondary market, if it is a tradeable bond.

Major rule of Basel-III norms strictly implemented in India

After the liquidity problems and capital crunch that banks had to face during the global financial crisis, central banks got together and decided to formulate new rules (called the Basel-III norms) that would assist banks maintain stronger balance sheets.

One of the key rules introduced in India was that banks must maintain capital at a minimum ratio of 11.5 per cent of their risk-weighted loans. Of this, 9.5 per cent needs to be in Tier-1 capital and 2 per cent in Tier-2.

Tier-1 capital includes equity and other forms of permanent capital that stays with the bank. This is due to the fact that banks cannot fully rely on loans and deposits as they keep flowing in and out. AT-1 bonds are also part of this 1st tier capital.

The problem:

Provide higher interest rate than other bonds. Thus, the higher yield when compared to secured bonds is the main attraction for the investors.

They also have higher risk which is reflected in the rating for these bonds. It is one to four notches lower than the secured bond series of the same bank. For example, while ICICI Banks’s tier-II bonds could have a rating of AAA by Crisil, but its tier-I long-term bonds will be rated AA+.

AT-1 bonds are complex hybrid instruments, ideally meant for institutions and HNI type investors who have higher risk taking ability. They can decipher the terms of the security and assess if their higher rates compensate for their higher risks.

But in India, these bonds have been sold to a number of retail investors as fixed deposit or NCD substitutes.

Retail folks have been able to acquire these bonds through two routes — initial private placement offers of AT-1 bonds by banks seeking to raise money; or buying already-trading AT-1 bonds in the secondary market.

Not to forget, AT-1 bonds carry a face value of ₹10 lakhs per bond.

Conclusion

Whenever a bond offers heavy yield don’t just run to lay your hands on it, look for the shark in the fishnet. Means higher returns is good, but assess or get assessed the risk-reward ratio and will you be able to bear it.

Will meet you in the next blog, till then -

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Why are AT-1 bonds in news - all you need to know about the AT-1 bonds controversy

Disclaimer: This blog is only for educational purpose and in now way intends to propel anyone to invest in the securities mentioned above. Any investment decision should be your own based on consultation with your financial advisor and dear ones. Investing or trading involves risks thus, make decisions accordingly.

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Written by: Aastik Pasricha