Are Indian AT-1 bonds properly rated and priced?

Radhika Merwin | Updated on March 19, 2020 Published on March 17, 2020

Risks involved with these bonds are reflected in neither the ratings by Indian agencies, nor the coupon rate issued in the country

All the spectacle around the YES Bank fiasco has brought Additional Tier-1 bonds (AT-1 bonds) issued by banks under the scanner. And rightly so. In recent years, both public and private banks have increasingly relied on AT-1 bonds to raise capital. Investors, lured by higher returns, have also been lapping up these bonds. But these investors that drew false comfort from the relatively high ratings assigned to these bonds and the remote possibility of loss of principal, were in for a rude shock when the RBI abruptly moved to write down the AT-1 bonds issued by YES Bank. After much noise made by institutional investors, YES Bank’s AT-1 bonds worth ₹8,415 crore were written down to zero.

While the move has left investors high and dry, it has also drawn much-needed attention to the underlying issues in these bonds. About five years ago, a report explained how investors were overlooking the inherent risk in these bonds, and that their ratings and pricing needed an overhaul. After the YES Bank crisis, it has become critical to take stock of these issues.

Ratings review

Basel-III compliant AT-1 bonds come with a built-in ‘loss absorbency’ clause, which means in case of stress, banks can write off such investments or convert them into equity.

The principal loss absorption can be triggered by pre-specified trigger of CET-1 falling below 5.5 per cent before March 2019 and 6.125 per cent thereafter. At the instance of the RBI, bonds can also be written down upon the point of non-viability (PONV) event — which is what happened in YES Bank’s case.

The question is, are these risks adequately reflected in the ratings given by Indian rating agencies?

A look at the data compiled from Bloomberg for 73 active Indian AT-1 bonds issued by various banks suggests that most of them are currently rated as AA+ or AA-. This indicates high degree of safety regarding timely servicing of financial obligations. YES Bank’s AT-1 bonds were also rated AA when they were issued, but were downgraded to BBB- in February this year and finally to D, recently.

The rating criteria put out by CRISIL and ICRA suggest that while they do take note of the risks associated with such bonds, they notch the rating down by just one or two levels from the bank’s overall corporate credit rating (CCR) in most cases.

Is this notch-down sufficient to reflect the underlying risks in AT-1 bonds? Hardly, if one were to consider the ratings assigned by global rating agencies for similar bonds.

For instance, Fitch’s rating criteria for AT-1 bonds factors in at least a four-levels notch-down from the bank’s viability ratings (equivalent to CCR domestically). Hence, most AT-1 bonds issued by global banks are rated BBB(+/-) or BB(+/-) at best.

Resultantly, the difference between the ratings of Tier-2 (that carry relatively lower risk) and Tier-1 bonds globally is at least 2-3 notches. But in India, the difference is mostly just 1-2 notches, indicating that the risk in AT-1 bonds is understated here.

While both Tier-1 and -2 instruments have significant loss-absorption features, the former are meant to absorb losses on a going-concern basis — the loss-absorption trigger kicks in fairly early. Hence, the high loss-absorption features of Tier-1 bonds can bail out depositors as well as investors in Tier-2 bonds, well ahead of a crisis or stress.

One of India’s leading rating agencies says that the PONV trigger is a remote possibility in the Indian context, as timely intervention by the RBI will avoid a situation wherein a bank becomes non-viable. But the RBI’s write-off of YES Bank’s AT-1 bonds, triggered by the PONV event, has turned this theory on its head. It is time Indian rating agencies critically review ratings given to AT-1 bonds.

The AT-1 bonds issued in India also do not offer a coupon rate commensurate with the risks. A look at the coupon offered by Indian banks on these bonds suggests that the rates are about 75-100 bps above that offered to Tier-2 bonds. Experts say that globally, the differential between the coupons on the two bonds is at least 200-300 bps.

Relaxing the norms

To some extent, the RBI relaxing certain norms under AT-1 bonds and allowing retail participation has also led to mindless rush towards these bonds. For instance, in 2016, the RBI allowed banks to pay coupons out of past profits and revenue reserves if the current-year profits were not sufficient (provided the bank meets the minimum capital requirements). Then, in 2017, it allowed banks to pay coupons out of statutory reserves. This perceptibly reduced the risk of non-servicing of coupon on Tier-1 bonds and made it easier for banks to raise capital, even in stress times.

Also, the call option was made permissible after five years of issuance of the bond (against the earlier 10 years). This led to gross misselling of the instruments by relationship managers, that sold it as a five-year paper (expecting banks to exercise the call option after five years) to gullible retail investors.

After the YES Bank episode, the RBI needs to review norms and tighten the checks, to protect retail investors.

Published on March 17, 2020

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