BackOpinion | Yes Bank’s shadow on the Indian market for AT-1 bonds
These are useful instruments for banks and their market should revive once the risks are better understood
PremiumThe failure and restructuring of Yes Bank is a highly significant event in many respects. One of the dimensions is its impact on future additional tier 1 (AT-1) bond issues by banks. There is a palpable fear that the AT-1 market will turn inactive. The reason offered is that AT-1 investors will be fearful of losing their entire investment, as has happened in the case of Yes Bank.
This is a very important issue. Banks are allowed, under Basel-III norms on capital adequacy, to raise funds through AT-1 bonds. These serve a very useful purpose, as AT-1 bond holders provide long-term capital (close to equity), without diluting the interests of a bank’s shareholders.
According to the pecking order theory of a bank’s capital structure, well-performing lenders are hesitant to issue new shares. However, such banks may, at times, not have the ability to leverage their balance sheets even when they need to do so for growth. AT-1 capital serves such lenders well.
The current fears, however, appear overdone. I would venture that the AT-1 market in India will not only survive, but improve.
Yes Bank AT-1 investors had effectively signed a bond agreement that allowed for a full write-off in case these bonds needed to be restructured in special circumstances. In return, they earned a much higher rate of interest than a senior bond holder would. This was compensation for the higher risk they took on.
Many observers, however, seem shocked that Yes Bank’s AT-1 bonds have been written off. Though not irrational, such reactions can be traced to a psychological bias. The default on these AT-1 bonds is the first ever on such bonds in the Indian market. Hence, the possibility of such an occurrence was neither anticipated nor properly discounted by analysts and investors.
But imagine if no AT-1 bond issuer were to default for a long time and investors kept earning a coupon rate much higher than what they got on senior bonds. That would have surely been odd. Hence, the Yes Bank AT-1 default may actually have helped drive rationality into the country’s bond market.
Henceforth, AT-1 bond investors will surely be more conscious of the real possibility of a default. That should push them to do two things.
First, evaluate the higher risk of default by such a bond’s issuer, and price it accordingly; and second, pay attention to how bonds are rated by credit rating agencies.
On the first point, the pricing of all bonds will likely be reviewed. The basic principles of bond pricing are the same. However, AT-1 bonds bear greater risk than senior bonds. So, the evaluation will have to be a bit more complex. If the risk of debt restructuring had not been discounted fully by investors all this while, as appears to be the case, expect the risk premium to go up now. As a result, AT-1 bonds are likely to yield more.
The second point would actually prove to be a positive development for the bond market. Investors will become more discerning with respect to credit ratings. This means that better rated bond issuers would be able to access funds cheaper than others. This would deliver an extra measure of fairness to the Indian bond market and thus serve the cause of better risk pricing in general.
It should be underlined here that an AT-1 bond is a structured bond that is designed only for sophisticated investors. Such investors—typically institutional—should have the ability to use sophisticated tools and techniques to assess specific risks and, thereby, price these bonds appropriately. That said, a basic pricing model can even be developed on an Excel spreadsheet, supplemented by analytical tools such as R or python programmes. However, advanced models are available over the counter these days from specialized treasury application vendors as well.
A real pricing edge for investors would lie in two broad areas.
First, they must estimate the likelihoods of various scenarios that could emerge in the future. This would mean thinking about numerous potential developments and the impact they could have on the payback ability of a bond issuer. This would include scenarios related to the business itself, apart from governance, regulatory and other factors. For example, how will the bonds be treated in the event of a restructuring? Surely, they need not be written off entirely in all cases.
Second, investors should customize or develop models to mimic the real evolution of prices. This would require the estimation of various parameters that go into the determination of a bond’s value at multiple points of time. For example, how will the recovery value be affected by the bank’s level of deposits, equity capital, or for that matter the state of its business? Additionally, how will interactions between these varying factors play out?
These are not new methods for bond pricing. But the process of determining what models do the best job is still evolving in India. This is because the markets for derivatives and structured products are still limited in size and scale in the country.
How India’s AT-1 bond market evolves from here would be interesting to watch. Once the dust settles over Yes Bank’s AT-1 bonds and investors get more discerning, better rated banks may find an opportunity to use these to their advantage. Regulators and policymakers could help by dispelling irrational fears in the wake of Yes Bank’s failure, which must not be allowed to hinder the growth of India’s bond market.
Hemant Manuj is an associate professor and area head, finance, at Bhavan’s SPJIMR
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