What are Additional Tier 1 (AT1) or perpetual bonds

Additional Tier 1 (AT1) or perpetual bonds are now hogging the limelight as large banks including HDFC Bank, Axis Bank are tapping offshore markets for the first time via such instruments. The local market has dried up completely as mutual funds, traditional investors in those papers have shied away.

What is AT1?

It is a kind of bond billed as a quasi-equity instrument. While such securities offer greater returns, the risk is also higher. These add to a bank’s capital strength aiding any bank to maintain regulatory thresholds for capital adequacy, a gauge for accounting compliance in proportion to expanding credit business.

For a corporate, these securities are popularly termed as perpetual bonds, instead of AT1. They do not form part of capital formation unlike banks.

When Bharti Airtel raises perpetual bonds, it is different from that of HDFC Bank raising AT1. Usage is the key differentiator here.

Key features of AT1:

These papers do not have any fixed maturity but generally have a five-year call option, an exit route for investors when issuers call such bonds back after the stipulated period. These papers are always rated three-four notches below the same issuer’s general corporate rating.

What’s the risk element?

These are riskier instruments as repayment obligations come lower in the waterfall mechanism. Those liabilities are not top priority for any borrower/issuer at time of any crisis. The principal or any accrued interest can be written down partly or fully. If a borrower’s common equity tier 1 (CET1) ratio, an international standard for capital, falls to or below 6.125 percent from October onwards this year.

History of investor loss:

On the domestic turf, investors used to presume it as a five-year paper. Borrowers and investors used to agree on an informal agreement that the issuer would call it back after five years.

None thought AT1 would falter. No investment is risk-free in this world as the popular saying goes.

Private sector lender Yes Bank reminded investors of the age-old adage. Under new management it decided to write off the AT1 obligation. Some of those securities were allegedly mis-sold to wealthy investors.

Did Yes Bank trigger panic?

Yes, it did. This prompted regulators like the Securities Exchange Board of India (SEBI) coming out with stricter regulations for AT1 investments. The regulator was concerned over the valuation process by mutual funds that hold a lot of retail investments.

What SEBI did?

The capital market regulator directed mutual funds to cap ownership of bonds with special features at 10% of the assets in a scheme and value them as 100-year instruments from April, potentially triggering a redemption wave. The order came on March 10, 2021.

Later, the capital markets regulator eased valuation rules but with some riders after the finance ministry had asked Sebi to withdraw its order to mutual funds.

Why did the local market dry up?

The appetite for AT1 bonds has lost as fund houses now appear not so keen to buy papers sold by banks/institutions/companies in the local market.

MFs are now often seen highlighting hurdles in valuing those securities following new guidelines by the SEBI.

Between FY18 and FY21, perpetual bonds sales by banks have nearly halved to Rs 18,772 crore from Rs 34,860 crore three years ago, show reported data. Beginning this financial year, the bond street did not have any single issuance on the AT1 lane.

So offshore sales way forward?

Banks barring the State Bank of India never tapped the overseas market for AT1 sales. There was reportedly one issuance by the SBI way back in 2016 for about $300 million.

HDFC Bank set a precedence recently raising the largest AT1 sale offshore for $1 billion. Many more like Axis Bank, Union Bank of India and State Bank of India are in the process of building such issuances, media reports suggest.

What evinced interest for international investors?

Internationally interest rates are at record lows. US Treasury benchmark is still yielding about 190 basis points lower than its near-term high of 3.08 percent in October, 2018. Global central banks have resorted to easy monetary policies, which are unlikely to taper before this year-end at least.

Yield hungry investors are scouting for higher rates of returns especially when equity valuations are seen overshooting.

Will the local market revive for those quasi-debt papers?

Unlikely unless wrinkles are ironed out. Still some large banks will try convincing fund houses, who may bet only after easing of valuation regulation that is unlikely.

The deployable money by fund houses could well find alternatives like investment trusts.

Any scope for secondary market trade?

Like primary sales, the secondary market has also dried up with securities changing hands occasionally. This makes the market more illiquid.