AT1 perpetual bonds of banks in question
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Over the past few years, perpetual bonds issued by banks as part of Additional Tier 1 (AT1) requirements under Basel III norms, have caught the fancy of institutional investors (mutual funds and other big boys) as well as individuals (high networth individuals and the mass affluent segment). Rightly so. This instrument presents a classic case of ‘calculated risk’ where there is a marginally higher risk but there is compensation in the form of relatively higher yield.
There are two risks in AT1 perpetual bonds: a) Coupon can be paid only out of profit and reserves, i.e., coupon may not be paid if the bank is deep in losses; and b) in the unlikely event of the bank winding up, holders may have to share the losses like equity shareholders. However, this is unlikely, given the implicit government support. The nearest risk these AT1 bonds ever came to was the apprehension that coupon may be skipped, but that has not happened so far.
This context has become more relevant recently due to the evolving situation. Every day, new non-performing assets (NPAs) in banks are being discovered and provided for in banks’ books, which is leading to losses. This has aggravated the apprehension because banks are being placed under prompt corrective action (PCA) by the Reserve Bank of India (RBI), which puts restrictions on the activities of the bank. So far, the central bank has placed 11 out of 21 public sector banks under PCA (those that have issued about Rs22,000 crore worth of AT1 bonds) and five more banks are reportedly in line (another Rs15,700 crore of AT1 bonds).
Earlier, banks could pay coupon on these bonds out of profits and revenue reserves. But after an amendment in February 2017, coupon can only be paid out of profits and statutory reserves. While this calms the apprehension to an extent, it is not the solution.
What must be noted is that investors buying these bonds are not buying so much to hold till perpetuity but with a view that the bonds will be called when the call option is due. Under Basel III, the call option is 5 years from date of issuance whereas under Basel II, it was 10 years. When the issues of banks’ losses were evolving, the call dates were not yet due. In such a situation, the first entity to buy back AT1 perpetual bonds earlier than the stated call date was Central Bank of India, which it did in February 2017. The bank did it under a clause in the Issue Memorandum, which authorized them to call back before the scheduled call option date.
Recently, a clutch of public sector banks, particularly the weaker ones, are calling these bonds back, stating that their being placed under PCA is a ‘regulatory event’, which entitles them to buyback even before the call date.
In these cases, though the Issue Memorandum does not specifically allow them to call back before the scheduled date, there is a communication from the central bank in January 2018, stating that placement of a bank under PCA may be considered a regulatory event and the bank may exercise a call option.
So how do you react to this early call back? From a macro perspective, it is a positive move as it restores faith in the system. If anybody had a doubt if coupon will be serviced on the due date or not, the bond itself is being called back, thus putting these apprehensions to rest. Anyway, most investors were waiting for the call option date. However, there are two flipsides from the investors’ point of view. One is the relatively higher coupon of AT1 bonds, which was expected till the scheduled call date, is being enjoyed for a shorter period. And two is that some investors bought these bonds in the secondary market at a price premium, i.e. price higher than the face value, while the buyback is happening at face value. For these investors, who bought the bonds at a price premium, it will result in a loss.
Case for investment
In a situation where banks’ fundamentals are weakening, losses are mounting and serviceability of AT1 bonds has reduced, the early call-backs were required to sustain investors’ faith in the ecosystem of public sector banks and AT1 perpetual bonds, given that public sector banks have issued more than Rs60,000 crore of AT1 bonds. Unfortunately, it is resulting in a loss for some investors and the investor does not have a choice. The issuers must have given a thought to this aspect.
To be fair, it is practically difficult to administer different buyback prices for different purchase prices in the secondary (as against primary) market.
The takeaway from this event is that while bond investments happen based on yields (as against coupon rate), in case of AT1 bonds, it is advisable to check the PCA status and secondary market price against the face value. Even if you stick to the relatively better AT1 bonds as against those of weaker banks, you will get a return kicker over the regular bonds from the same issuer.
Joydeep Sen is founder, wiseinvestor.in