Opinion | Why Yes Bank AT1 bonds are being written down to zero and not the shares

Additional tier 1 (AT1) bonds are in the news for all the wrong reasons. Yes Bank has issued such bonds worth over ₹8,000 crore and it turns out that the Reserve Bank of India (RBI) has exercised a clause no one thought they would, and the bonds are going to be worthless. This has taken a large number of investors by surprise because bonds are generally considered to be superior to equity, and why should bonds be written down while shares are not? The answer, my friends, is blowing in the offer document of such bonds.

AT1 bonds are quasi-equity instruments. These are meant to be like equity, but are structured as bonds. The promise of equity is: give a company some money as equity, and it will use that money to grow. There is no obligation to pay any dividend. There is no obligation to return the money ever, and the company can use the money as it wishes. That’s the essence of equity capital.

Banks require capital so that they can grow their lending books. For each ₹100 lent, they need to have, say, ₹10 as capital, according to RBI regulations. This capital is “Tier 1 capital”, which is as flexible as equity capital (where there’s no need to return the money or to pay dividends).

But equity capital is expensive and dilutive. If you issue more, you spread profits across more shares, which reduces the price of each share. To avoid this, the Basel III regulations provide for something called “Tier 1 capital instruments”—they are not equity, but can be considered close enough. Among them, Indian banks chose to issue “perpetual debt instruments” as AT1 bonds.

These are high interest-bearing bonds that have no maturity date. Banks pay the interest rate every year. The bonds will continue forever (no maturity date), but the bank can “call” the bond back by paying the maturity value, after 10 years from the issue. The bank will pay interest only when it has enough profits to do so. And the bank, with RBI’s approval, can actually say it won’t pay back any interest or principal at all, if there’s a trigger, such as losing so much money that the bank’s tier 1 capital ratios fall below a certain limit or when the bank needs massive capital infusion. In the case of Yes Bank, this is what has happened.

AT1 bondholders are in shock, and are asking why their bonds have to be written down to zero when shareholders get to continue. But let’s be clear about what’s happening here: it’s not a liquidation. Seniority of bonds over equity matters only in liquidation. As we have seen in the case of Bhushan Steel or other bankruptcy resolutions, bondholders may take a hit (in Bhushan, lenders took a 30%-plus hit) but equity holders remain as they are (Bhushan Steel equity shares traded at ₹30 or so throughout). Equity can be diluted substantially (in Bhushan’s case, over 90%) by a new buyer. The State Bank of India (SBI) will buy enough to own 49% of Yes Bank, and it’s quite likely they will bring in other investors too at the ₹10 price, so much that the current investors will go down to a fraction of the new Yes Bank.

It’s a “resolution”, not a liquidation. In a resolution, bondholders can agree to take a haircut and dilute equity instead. In AT1 bonds, bondholders have agreed beforehand that they can be written down to zero in case the bank has to be rescued. And that’s why they’re getting nothing.

This has happened in Europe earlier. Such bonds are called “bail-in” bonds, and in many banks in Italy and Spain, holders of these kind of bonds have seen either conversion to equity or a haircut on repayment, or been completely wiped out.

Investors in AT1 bonds have been seeing situations that warned them of trouble. A few years ago, certain banks were placed in RBI’s Prompt and Corrective Action and they forcibly bought back all the AT1 bonds at par. This was done to keep the tier 1 bond market from collapsing, if the bond was written off then. Again, recently, a public sector bank warned that it will not pay up for the bonds at the “call” option date, the date on which an otherwise perpetual bond can be redeemed. The reaction was intense, and the bank relented and called the bonds. But these were signs that there was stress, but the institutions paid no heed and continued to hold such bonds. Now, the risk is really upon us all.

The market is now realizing, slowly, that such bonds are not supposed to be cheap. The yields in the market have gone up, signifying that people want higher interest rates if they are to take such risks. This is healthy, but at high rates, no one may want to issue AT1 bonds at all. But that might be good, since it is a financial instrument that is actually as risky as equity, but disguises itself as a bond.

Deepak Shenoy is chief executive officer, Capitalmind Wealth