The risky rush for bank bonds

Banks, both public and private, have been stepping up their capital raising efforts in the last one year to meet the Basel III requirements as also to fund their growth, but with one notable difference.

While private banks have been able to raise funds from the capital market, state-owned banks have resorted to issuing Basel III compliant additional tier 1 (AT1) bonds. These come with a ‘loss absorbency’ clause which means that in case of stress, banks can write off such investments or convert them into equity.

The Reserve Bank of India also made the deal sweeter for banks by tweaking some of the norms last year — allowing shorter maturity of up to five years, temporary write-downs at pre-specified trigger points, allowing retail participation, and permitting payment of dues from past reserves.

But given that the pressure on asset quality in most of these banks is showing no signs of abating, these instruments pose a serious risk to investors. Relatively better ratings (higher than global agencies) and inadequate coupons offered on such bonds only heighten the risk further.

Given that the ability of state-owned banks to generate internal capital is weak and their access to equity markets to raise capital limited, they will continue to rely on AT1 bonds to fill their capital needs. Public sector banks (PSBs) need to raise about ₹4.6 lakh crore in tier 1 capital over the next four years.

AT1 instruments are riskier because default could be triggered by any of the following events: a drop in capital conservation buffer (nil for March 2015, increase by 0.625 per cent every year to reach 2.5 per cent in March 2019); drop in CET 1 (common equity tier 1, below 5.5 per cent by March 2019 and 6.125 per cent thereafter); point of non-viability (PONV); and in the event of loss.

On reaching a pre-specified trigger point, banks can write down the principal value of the bond or convert into equity shares. Earlier, the rule was to permanently write down the loss in case the bond issuer bank was in trouble. After the amendments made by the RBI last year, banks can temporarily write down the principal value of the bond.

The RBI also reduced the maturity of the bond. The call option, or the freedom given to banks to buy back the bonds, has been reduced to 5 years from 10 years earlier.

While these tweaks have made it easier for banks to raise money through this route, they have not adequately addressed the risk attached to these bonds.

For one, the ability of state-owned banks to fulfil their obligation under AT1 remains uncertain. Aside from writing down the loss, banks can also exercise their right of discretionary payment of coupons before reaching the pre-specified trigger point. Banks have full discretion to cancel coupon payments at an early stage of trouble at the bank and thus pose significant risk to investors.

During the crisis at United Bank of India, the bank’s tier 1 capital fell below the mandated 6.5 per cent level. While no other PSB is currently in the same boat, there are many (Union Bank, Central Bank and IOB, to name a few) whose CET ratios are way below the comfort level of 8 per cent. A rapid rise in bad loans can easily push many of them to the brink.

For another, domestic rating agencies have been assigning ratings higher than those given by global ratings agencies for similar bonds.

For instance according to Fitch Ratings’ recent report on Asian Banks’ issuance of AT1 bonds, it stated that since coupon omission — the first point of loss absorption — will be triggered when needed, these instruments would be rated in the single ‘B’ range.

Bank of India’s ₹2,500 crore AT1 bond issue was rated AAA by Brickwork last year. Crisil has assigned A minus for Central Bank of India’s AT1 bond issue and AA minus for Union Bank and Dena Bank’s issue.

According to Crisil’s Chief Analytical Officer Pawan Agrawal, domestic agencies assign ratings on a national scale, while the global agencies use a global scale. The approach, however, according to him, is similar.

Ratings for tier 1 instruments are notched down by both domestic and global rating compared to ratings assigned to the tier 2 bonds. Crisil has rated tier 1 instruments of eight PSBs; their ratings are two or three notches below the tier 2 instruments.

While this level of notch-down appears to factor in the additional risks embedded in the tier 1 instruments in relation to tier 2 bonds, the overall rating for such bonds needs a re-look. Any bond issued under Basel III norms, inflict losses on investors. In both tier 1 and tier 2 bonds, banks may refuse to pay the coupon in times of distress.

The risk associated with such instruments also warrants a higher coupon rate than, say, senior debt or tier 2 bonds issued by banks. But a look at the recent issues suggests that banks have been able to get away by offering a fairly low return. For instance, Oriental bank of Commerce issued tier 2 bonds in October 2014 with a coupon of 9.2 per cent. In February, when the bank raised tier 1 bonds, it offered an interest rate of 9.48 per cent, only about 30 basis points higher than that offered for its tier 2 bonds.

Falling interest rates have helped these banks raise funds at a cheaper rate. The RBI allowing banks to pay their dues by dipping into past reserves has also increased the investor appetite for these bonds. Before this relaxation, Bank of India, which came out with a similar issue in August last year, offered a higher 11 per cent interest.

After the amendments made last year, banks are also allowed to tap retail investors. But these instruments are highly complex, and exposing retail investors to them when our markets are still testing waters for AT1 is not wise.

When a whiff of trouble at United Bank left the RBI and the government shaken at the prospect of the bank defaulting on its bonds and institutional investors bearing the loss, whether retail investors will be able to absorb the loss when a bank runs into trouble is something that the regulator needs to assess critically.

The fall-out from triggering the loss-absorption clause on banks’ AT1 bonds can lead to a series of downgrades in the country and will only increase the cost of raising such bonds in future.

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