Everything You Need to Know About AT1 Bonds

What is AT1 Bond?

Additional Tier 1 or AT1 bonds are perpetual bonds with no maturity date. Investors of these bonds do not get their principal back. However, the interest continues forever. Due to the perpetual nature of AT1 bonds, these are often treated and viewed as equity, not debt. 

How are AT1 Bonds Issued?

AT1 bonds are issued by banks in accordance with the directions of the Reserve Bank of India (RBI). Financial institutions usually issue such bonds to fulfil their capital adequacy requirements (CAR). CAR is an assessment of a bank’s capital and its risk-weighted assets. Capital adequacy norms were formulated under the Basel III accord of 2009 after the credit crisis of 2008. 

These bonds are contingent convertible bonds, a type of debt instrument that the bank can anytime convert into equity if its capital levels fall below the specified levels. This helps the bank to reduce debt while managing capital. AT1 bonds have a call option which allows the banks to buy back the bonds from the investors.

These bonds provide high returns but also carry greater risk. If the banking institution fails, these bonds are at risk. Suppose RBI finds a bank in an unstable condition, under pressure, and in a situation where it demands rescue. In that case, it can ask the bank to immediately withdraw their additional tier 1 bonds without seeking permission from the investors, therefore making AT1 bonds risky. Further, the issuer can also skip the interest payout if it is under financial stress.

Features of AT1 Bonds

1. No maturity date: AT1 bonds are perpetual, which means they come with no maturity date. However, these bonds have a call option which allows the banks to call it back after a certain period.  

2. Interest: AT1 bonds carry a higher interest rate than other bonds. The interest on these bonds is usually fixed and is reset at certain intervals. Banks also have the option to skip interest payments.

3. Liquidity: Investors can not return their bonds to the bank as there is no put option against these bonds. However, these bonds are listed on the stock exchanges, so the investor can liquidate these whenever in need.

4. Subordinate debt: In case of default, these bonds rank lower than the other debt, which is why these are subordinate debts.

5. High lot size value: These bonds’ minimum allotment size and trading lot size are ₹1 crore.

6. Pre-payment or recall: The bank can repay or call the bond anytime, even before maturity.

Risks of AT1 Bonds

1. Unsecured Bonds: Although these bonds provide a higher coupon rate due to their perpetual and subordinate nature, they carry higher risks and are unsecured. In financial distress, RBI may ask the banks to withdraw their Tier 1 bonds, and the investor might not receive any compensation.

2. Payment of Interest: These bonds usually carry a fixed interest rate, but the banks can defer or skip the interest payout, severely affecting the investor’s returns. 

3. Call Option: Investors treat these bonds as perpetual interest-paying securities. However, the banks can also recall the bonds conveniently, and the interest would stop accruing.

Regulations

The banks utilise AT1 bonds to make their core equity base larger and thus fulfil Basel III requirements. Basel III Norms were formed and introduced to manage the banking industry at the time of the global financial crisis in 2008. These norms mandate the banks maintain a specified amount of capital as a contingency fund. The bank’s capital is divided into Tier 1 & Tier 2 funds. Tier 1 is further divided into Common Equity Tier 1 and Additional Tier 1 Capital (AT1 Bonds). If the Tier 1 Capital goes below the specified limit, AT1 Capital will be forfeited to provide the capital to the bank. The AT1 bonds are considered going concern capital, meaning these funds will be used to meet the losses in the case of bank failure. 

The SEBI (Securities and Exchange Board of India) also issued certain guidelines for the mutual fund houses, which own over one-third of the total AT1 bonds floating in the market. SEBI mandated the mutual funds to value these debt instruments as 100-year bonds and also restricted the maximum investment into AT1 bonds to 10% of the total assets. However, this restriction of 10% has been deferred for two years in consultation with the Ministry of Finance. 

Why do banks use AT1 Bond to raise money?

Banks use AT1 bonds to raise money because these instruments are designed to provide a stable source of capital for the bank while allowing it to maintain flexibility in managing its capital structure.

AT1 bonds are an essential tool for banks to raise capital and manage their capital structure in a way that balances stability and flexibility. However, investors in AT1 bonds should be aware of the risks involved, including potential losses if the bank runs into financial difficulties.

Conclusion 

AT1 bonds are high-risk, high-return perpetual securities providing higher returns than traditional fixed deposits. Banks keep raising these bonds occasionally to meet their capital requirements. The investors have, however, become cautious of such bonds after the Yes Bank incident wherein the bank entirely wrote off such bonds, and investors lost their invested amount on the lookout for a higher return investment alternative.

Frequently Asked Questions (FAQs)