Additional Tier 1 bonds "EMPOWER IAS"

Context:

State Bank of India (SBI) said it raised ₹4,000 crore via Basel-compliant Additional Tier 1 bonds at a coupon rate of 7.72%.

Background:

Additional Tier – 1 (AT-1 Bonds) Bonds are a type of perpetual bonds that don’t have any expiry date which is issued to raise long term capital.
In March 2020, the Reserve Bank of India came up with a proposal to write down AT-1 bonds. This write-down was – part of a restructuring package for Yes Bank – led by the State Bank of India.
AT-1 bonds were first conceptualized following the disastrous global financial crisis of 2008 when a lot of banks were closed down.
AT-1 bonds are like standard bonds but have a comparatively higher rate of interests. They are also listed and traded on stock exchanges. This means that the person holding the bond can sell it in the secondary market in case funds are required.
Banks issuing AT-11 bonds can even reduce the bonds’ face value.
AT-1 bonds are regulated by the Reserve Bank of India (RBI). If there is a need for RBI to bail out a bank it can tell the bank to write-off its outstanding AT-1 bonds without necessarily consulting its investors.

What is Additional Tier (AT)-1 Bond?

AT-1 Bonds are a kind of perpetual bonds without any expiry date that banks are allowed to issue to meet their long-term capital requirement.
AT-1 bonds are a type of unsecured bonds that banks issue to shore up their core capital base to meet the Basel-III norms.
Basel III norms require Indian banks to maintain a total capital ratio of 11.5%, split into 8% in tier 1 capital (own equity, reserves etc.) and tier 2 (supplementary reserves and hybrid instruments).
They are treated as quasi-equity instruments under the law.
The Reserve Bank of India is the regulator of AT-1 bonds.
Like any other bonds, AT1 bonds are issued by banks and companies, which pay a fixed rate of interest at regular intervals.
The issuing bank of these bonds has no obligation to pay back the principal to investors.
These bonds are listed and traded on the exchanges.
The investors cannot return these bonds to the issuing bank and get the money.
It implies that there is no put option available to its holders.
The issuing banks have the option to recall AT1 bonds issued by them (termed call option).
The issuing banks can go for a call option five years after these are issued and then every year at a pre-announced period.

Key Highlights of New Rules for AT-1 Bonds

The SEBI has told the mutual funds to value the AT-1 perpetual bonds as a 100-year instrument.
- It implies that the MFs have to make the assumption that these bonds would be redeemed in 100 years.
The regulator has asked MFs to limit the ownership of the bonds at 10 per cent of the assets of a scheme.

Reasons for New Rules for AT-1 Bonds

The reason for withdrawal of valuation norms for AT-1 bonds might lead to mutual funds making losses and exiting from these bonds, affecting capital raising plans of PSU banks.
The government doesn’t want a disruption in the fund mobilisation exercise of banks at a time when two PSU banks are on the privatisation block.
The banks are yet to receive the proposed capital injection in FY21 although they will need more capital to face the asset-quality challenges in the foreseeable future.

Impact of New Rule of AT-1 bonds on Mutual Funds

The MFs have treated the date of the call option on AT1 bonds as maturity date.
The treatment of AT-1 bonds as 100-year bonds raises the risk in these bonds as they become ultra-long-term.
It could also lead to volatility in the prices of these bonds as the risk increases the yields on these bonds rises.
The bond yields and bond prices move in opposite directions.
It implies that higher yield will drive down the price of bond, which in turn will lead to a decrease in the net asset value of MF schemes holding these bonds.
It will be difficult for MFs to sell these to meet redemption pressure because these bonds are not liquid.
It would lead to mutual fund houses engaging in panic selling of the bonds in the secondary market leading to widening of yields.

Importance of AT-1 Bonds

These bonds are perpetual and carry no maturity date and instead, they carry call options that allow banks to redeem them after five or 10 years.
The banks issuing AT-1 bonds can skip interest payouts for a particular year or even reduce the bonds’ face value without getting into hot water with their investors.
If the RBI feels that a bank is tottering on the brink and needs a rescue, it can simply ask the bank to cancel its outstanding AT-1 bonds without consulting its investors.

In India, Basel III regulates AT-1 Bonds. Basel III norms require Indian banks to maintain a capital ratio of 11.5% divided into 8% in tier 1 capital and tier 2 capital.
It should be noted that AT-1 bonds are known as “unsecured subordinated perpetual non-convertible bonds” that constitute a component of a bank’s permanent capital. Banks issue AT-1 bonds so that Basel III norms regarding equity capital are met.

Basel-III Norms:

It is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector, post 2008 financial crisis.
Under the Basel-III norms, banks were asked to maintain a certain minimum level of capital and not lend all the money they receive from deposits.
According to Basel-III norms banks' regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier-1 (CET-1) and Additional Tier-1 (AT-1) capital.
Common Equity Tier 1 capital includes equity instruments where returns are linked to the banks’ performance and therefore the performance of the share price. They have no maturity.
Additional Tier-1 capital are perpetual bonds which carry a fixed coupon payable annually from past or present profits of the bank.
They have no maturity, and their dividends can be cancelled at any time.
Together, CET and AT-1 are called Common Equity. Under Basel III norms, minimum requirement for Common Equity Capital has been defined.
Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years.
According to the Basel norms, if minimum Tier-1 capital falls below 6%, it allows for a write-off of these bonds.

Features of AT-1 Bonds:

The following are features of AT-1 bonds:

No fixed maturity date: AT-1 bonds have no maturity dates as they are perpetual bonds that remain with the bank. Sometimes AT-1 bonds are sold as limited-period bonds because they come with a feature of a call option by the one issuing the bond.
Premature recall: AT-1 bonds come with a clause that allows a bank to repay it prematurely, if an unexpected event, such as new taxes or new regulatory laws, occur during the time of issuing the bonds
Interest Payouts can be skipped: One of the crucial features of an AT-1 bond is that there is an option to skip on interest payouts without creditors coming after the issuer for defaulting on interest payments. SInce AT-1 bonds are intended to increase capital of banks they can legally incorporate clauses that allow banks to default on interest payouts provided that their capital falls below the regulatory requirement.

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