The untold story of AT1 bonds

The concept of AT1 bonds were first introduced in the aftermath of the financial crisis in 2008. In the case of AT1 bonds, the principal losses would be imposed on creditors in the event of firm-level distress.

Mar 09, 2020 09:03 IST India Infoline News Service

BONDS
As the Yes Bank case unfolded, one new term that a lot of investors came across for the first time was AT1 bonds or (Additional Tier 1) bonds. These are bonds that are perpetual in nature and do not have any specified maturity. Banks are allowed to issue such bonds to shore up their Tier 1 capital as, being perpetual bonds, they are considered as quasi equity.

The AT1 bonds came into the limelight for two reasons. Firstly, the RBI decided to write off Rs10,800cr worth of AT1 bonds in the books of Yes Bank as part of the Reconstruction arrangement. That means, these bond holders will get nothing and investors will have to write off that entire amount. Secondly, IndusInd Bank opted to cancel its proposed issue of AT1 bonds as it feared that the RBI action in the Yes Bank case could negatively impact the appetite among institutional investors.
 
What exactly are AT1 bonds?
The concept of AT1 bonds were first introduced in the aftermath of the financial crisis in 2008. In the case of AT1 bonds, the principal losses would be imposed on creditors in the event of firm-level distress. In short, these bonds would not have recourse to the public purse. Under the Basel III norms, banks are required to maintain minimum Tier-1 capital of 6% of risk-weighted assets.
 
This Tier-1 capital can be composed of 4.5% common equity and 1.5% of additional tier 1 bonds (AT1). The unique feature of AT1 bonds is that it can be called after five years of issue. At that point, either the bonds can be redeemed or they can be converted into equity. If the issuer falls into financial distress, holders of AT1 bonds have no recourse.
 
Why do institutions prefer to invest in AT1 bonds?
Why are institutions interested in investing in AT1 bonds? While AT1 bonds are clearly high risk in nature, they also offer higher yields. At a time when most institutional investors were starved for yields, the AT1 bonds offered the perfect alternative for them. For example, while a typical AAA rated Tier-2 bond pays an interest rate of 7.5%, there is a 150 basis points premium on AT1 bonds as they are able to earn around 9% on an average.

While the bank has the option to pay the coupon forever, they also have the option to call back the bonds and either redeem the bonds or convert them into equity. Basically, it is the higher yields that are the big attraction for AT1 bonds. However, risks have come to the fore in the Yes Bank case.
 
Are retail investors exposed to AT1 bonds?
The AT1 bonds are generally targeted at institutional investors and HNIs although there is no bar on retail investors investing in such bonds. However, scores of retail investors are exposed to AT1 funds indirectly through the bond funds and the hybrid funds that they may be holding. If you look at the case of Yes Bank, nearly 25% of the AT1 bonds issued by Yes Bank are held by Indian mutual funds. Let us now look at the magnitude of the indirect risk.
Funds with over Rs100cr exposure to AT1 bonds of Yes bank
Scheme Name Exposure to Yes Bank AT1 Bonds Exposure as a (%) of fund AUM
Nippon India Equity Hybrid Fund Rs638cr 8.11%
Nippon India Credit Risk Fund Rs540cr 10.96%
Nippon India Strategic Debt Fund Rs436cr 21.25%
Franklin India ST Income Plan Rs281cr 2.71%
Franklin India Credit Risk Fund Rs135cr 2.42%
UTI ULIP Fund Rs128cr 2.88%
Nippon India Hybrid Bond Fund Rs103cr 8.06%
Data Source: Morningstar
 
Clearly, the impact on the retail investor returns will be significant where the exposure to Yes Bank AT1 bonds is greater than 5% of the overall AUM and that would make half of the above funds vulnerable to significant write-offs.
 
The overall exposure of the mutual funds at an AMC level can be summarized as under.
Asset Management Company Overall Exposure to Yes Bank AT1 Bonds
Nippon India Mutual Fund Rs1,806cr
Franklin Templeton Mutual Fund Rs476cr
UTI Mutual Fund Rs287cr
Kotak Mutual Fund Rs94cr
Baroda Mutual Fund Rs59cr
Data Source: Morningstar
 
The above five AMCs account for 97% of the total exposure of Indian mutual funds to the AT1 bonds of Yes Bank. That is an indirect exposure that retail mutual funds investors are carrying, perhaps unknowingly.
 
Key takeaways for investors from the AT1 bonds story
From IL&FS bonds to DHFL bonds to bonds guaranteed by Zee shares and now AT1 bonds; it has been a rough journey for debt funds in the last 2 years. For investors, it is a reminder that debt funds are not risk-free, as a lot of them would like to believe. An assessment of risks before investing in debt funds would do a world of good to your long-term investment plan.

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