Why investors in Yes Bank AT 1 bonds should not cry wolf now

Even as depositors of YES Bank were handed a rude blow when the RBI placed month-long restrictions on withdrawals at ₹50,000, there was another set of investors who cried foul over the RBI’s directive. The RBI, as part of its draft restructuring scheme for YES Bank, decided to write down the bank’s additional Tier 1 capital (AT 1 bonds), permanently, in full. Mutual funds with exposure of around ₹2,700 crore to YES Bank’s AT 1 bonds are up in arms and are reportedly looking to initiate legal action against the RBI’s move.

While there are some reports of retail investors falling prey to mis-selling of such bonds, for institutional investors (who should have been aware of the inherent risk in such bonds), it is only ironical that the RBI’s move should cause such pandemonium.

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

The publicly available term sheet of YES Bank’s AT 1 bonds, also clearly lay down that these bonds can be written down or converted into equity if pre-specified trigger of drop in CET 1 (common equity Tier 1) or point of non-viability (PONV) event occurs. Interestingly of the ₹8,800-odd crore of YES Bank’s AT 1 capital (as of September 2019), a chunk of the bonds appears to have been issued in 2016 (₹3,000 crore) and 2017 (₹5,415 crore). These bonds carried AA rating (by ICRA) through most of 2017 and 2018 before being downgraded to BBB by the end of 2019. Offering a coupon of 9-9.5 per cent, they appeared to have drawn in investors in search of high-yielding debt instruments.

While investors possibly took false comfort in such loss absorbency clause not being triggered yet, the RBI writing down such bonds for the first time in the history of the Indian banking sector is a wake-up call for investors. Ratings and pricing of these bonds will also need to be reassessed to reflect the actual risk in these bonds.

Clearly laid down rules

AT 1 instruments are inherently riskier because principal loss absorption (through write-down or conversion into equity shares) can be triggered by pre-specified trigger of CET1 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 a PONV event happening.

These are clearly laid down in the RBI’s master circular on ‘Implementation of Basel III Capital Regulations’.

As per RBI’s circular, the PONV trigger event is the earlier of a) decision that a conversion or write-off, without which the firm would become non-viable, is necessary, b) decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable.

The RBI has written down YES Bank’s AT 1 bonds triggered by the PONV event.

The norms also state that if the authorities decide to reconstitute a bank or amalgamate a bank with any other bank under Section 45 of BR Act, 1949, then such a bank will be deemed as non-viable or approaching non-viability.

Invoking Section 45, the RBI has laid down a draft reconstruction scheme for YES Bank. In doing so, it has also decided to fully write-off AT 1 bonds, which are well within the clearly laid down regulations.

But why choose a write-down option and not offer to convert the bonds into equity, is the argument laid down by many bondholders?

Why no conversion?

According to the RBI’s guidelines, banks can issue AT 1 instruments with conversion features either based on price fixed at the time of issuance or based on the market price prevailing at the time of conversion.

In case of YES Bank and many other banks, the AT 1 bonds appear to have a ‘non-convertible’ feature. It is unclear whether the RBI could still convert such bonds into equity at its discretion.

Even if the RBI did convert such bonds into equity could it have ensured that it would not breach any statutory / regulatory ceilings for maximum private shareholdings or group of related investors? This is critical given the massive number of shares RBI would have to issue to AT 1 bondholders in case of YES Bank.

If we assume that bonds would be converted at a price of ₹10/share (the same price at which SBI brings in capital as proposed in the draft reconstruction scheme), then bondholders would have to be issued around 880 crore equity shares in YES Bank. The existing number of shares in YES Bank is just 255 crore and SBI would be issued another 245 crore shares in the bank after it infuses capital. Hence, huge number of shares being issued to AT 1 bondholders could probably have breached regulatory caps on shareholding ceilings.

Time for reassessment

In recent years, both public and private sector banks have been resorting to AT bonds to raise capital. Investors have also been flocking to these bonds lured by the higher interest rate these bonds offer as against say, senior debt or tier 2 bonds issued by banks. The fall-out of the write-down of YES Bank’s AT 1 bonds can lead to a series of downgrades and increase the cost of raising such bonds in future.

This is something that the RBI will need to look into urgently.

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