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AT1 bonds: Risk has been reduced but caution is advised

The ability of public sector banks t o repay these bonds has improved, especially since new guidelines by the Reserve Bank

Capital-seeking public sector banks have increasingly sought issuing additional tier-I (AT1) bonds to raise capital. Also known as perpetual bonds, these allow banks to raise capital in compliance with Basel III norms. Unlike regular bonds, they don’t have a maturity date and the issuing bank can either repay the principal after a pre-determined date or continue paying interest forever. 

These bonds have a higher yield than regular bonds because of the higher perceived risk: the issuing bank has the prerogative to skip coupon payment. With some public sector banks reeling under losses, there were concerns on coupon repayment. 

Recently, Reserve Bank of India (RBI) revised the guidelines related to coupon servicing or interest repayment by these banks. Earlier, repayment could be done from profits or revenue reserves. But growing losses at some banks were a concern. 

New guidelines state, if the current year profits and revenue reserves are not sufficient, banks can use the statutory and other reserves to make payments on these bonds. Umang Papneja, managing partner and chief investment officer, IIFL Wealth Management Ltd, said, “The revised guidelines have a significant positive impact on the risk profile for AT1 bonds issued by public sector banks. The enhanced capability to repay coupon makes them more attractive." 

Banks’ ability to repay has increased. Krishnan Sitaraman, senior director, Crisil Ratings, said, “As per our estimates, reserves available to pay coupon on AT1 bonds have doubled, but for weaker banks, this has increased five times." 

RBI’s revised guidelines have also specified that banks should not account for balance carried forward from profit and loss account separately from the revenue reserves. 

Thus, it’s not enough to have a positive balance in one counter and a negative in another. It’s the net figure that holds importance.

Nikhil Johri, founder and chief investment officer, Trivantage Capital Management India Pvt. Ltd, which manages a fund with AT1 bonds, said, “In analysing these bonds, we were already considering the net amount available for payout. But there was some confusion among banks in making this calculation. This change helps to bring in clarity."

Johri added that weaker banks, despite improved conditions, continue to have annual profitability under pressure. However, the near-term perceived risk has reduced, it is lowered for now. 

Bond prices are inversely related to yields, and a fall in yield means gains, as prices rise. So, does it mean that AT1 bond yields could close the gap with those of regular bonds issued by the same bank? This may happen, but market forces are not accommodative at the moment. Johri said that with the RBI’s policy stance changing to neutral, bonds have been impacted negatively as yields have risen.

Given the perpetual tenure (comparable to a very long-term bond), any change that impacts market yields is likely to impact yields of such bonds, hence it may take some time for yields to fall. 

Johri added, “While the bonds could be repaid sooner, but they are perpetual bonds. If the market situation does not warrant lower coupon for bonds issues 3 years hence, there could be a situation where they don’t get called (bought back) by the bank." 

Repricing is not a given for all the issues. Sitaraman said, “Market has taken comfort in some public sector bank bonds, as default is not expected. Thus, bonds were already priced low and hence, scope for yields to come down materially may not be there."

The advantage, thanks to the changed guidelines, could translate better if there is an active secondary market. The lack of secondary market liquidity remains the top concern as you may not get the right price or even a buyer when you want to exit.

Risk attached to AT1 bonds has reduced but not dissolved completely. Thus, picking the right bank issuing the bond is critical. Fall in market yields for these bonds may be limited in the near term, but could pick up in coming months.

These are not your simple invest-and-receive-a-coupon kind of bonds. This is not a retail product, it is meant for investors with a high risk threshold and better accessed through advisers and professionally managed funds.