AT1 Bonds: We learn nothing from history
The German philosopher Georg Hegel famously said, “The only thing that we learn from history is that we learn nothing from history”. This quote perfectly summarizes the AT1 bond saga.
Thanks to the latest Credit Suisse fiasco, there is a big debate going on among market participants about how equity shareholders got back some money while bondholders were wiped off. Additional Tier 1 bonds or AT1 bonds are again in news as investors in Yes Bank AT1 bonds experienced déjà vu when Credit Suisse wrote them down this week. What are these bonds and why do banks issue them in the first place?
Origin of AT1 Bonds
The issue of excessive bank leverage was exposed by the global financial crisis of 2007–2008. It was believed that banks should operate with a bigger percentage of their own capital as opposed to borrowed capital to prevent a recurrence of this issue.
Hence, banks were permitted to issue an exclusive class of bonds known as AT1 bonds or perpetual debt to investors in order to strengthen their Tier 1 capital (permanent capital) and thus comply with the Basel III norms.
Features of AT1 Bonds:
No maturity date: Since they are a permanent component of the bank’s capital, similar to equity, they do not have a maturity date. After five years, banks can give a call option on these bonds, at which point they may or may not decide to redeem them.
Higher returns: They offer higher returns vs. plain vanilla debt instruments. They pay regular interest that is typically high yielding.
BUT
Higher risk: AT1 bonds are much riskier than regular corporate bonds. Let’s understand why.
Take for example a bank like Credit Suisse is liquidated, then the order of repayment is as below:
- FD investors
- Secured debt
- Unsecured or subordinate debt
- Perpetual debt or AT1 bonds
So you see, AT1 bonds ranks the lowest when it comes to repayment and hence carry a Principal Risk. Plus, banks have the option to either lower or totally forgo coupon (interest) payments on these bonds if it is not generating enough profits or is in trouble. In case of normal bonds or debentures, banks have to make coupon payments irrespective. So AT1 bonds also suffer from Coupon Risk.
But you may ask that atleast these bonds should rank higher than equity shareholders. But even that was not the case.
Yes Bank and Credit Suisse: AT1 Bond curse continues
Yes Bank had a considerable increase in its non-performing assets between September 2019 and March 2020.
To contain the situation, the RBI enlisted SBI to inject equity into the bank as a rebuilding plan was being developed. As a part of the rescue plan, the RBI decided to permanently write off the bank’s AT1 bond obligations.
Similarly, in March 2023, the struggling bank Credit Suisse’s AT1 Bonds or contingent convertible (CoCo) bonds worth $17billion were also written down by the Swiss regulator FINMA as it roped in UBS to buyout Credit Suisse.
Problem with the write off
We witnessed government intervention in both cases and while equity investors should be the first group of stakeholders to see their assets written off in times of bankruptcy, equity investors still received some value from their investments.
What happened to AT1 bond investors?
Yes Bank AT1 bondholders cried foul play. They expressed dissatisfaction over the fact that they were not informed of the principal or coupon write-off characteristics when Yes Bank employees sold them these AT1 bonds. According to SEBI’s investigations, Yes Bank employees misleadingly offered institutional investors’ bonds to retail customers and sold then as super FDs (Fixed Deposits) by relationship managers. Some of these investors had invested their retirement money in these bonds which got completely eroded in 2020. Ideally, this debacle would have been a lesson for retail investors to stay away from such risky instruments.
Have we learnt a lesson?
Unfortunately no. The appetite for AT1 bonds are back. HNIs seem to have shrugged off the risk caused by the Yes Bank debacle and continue to show interest in these risky instruments. Between July to early September 2022, several banks raised funds totalling ₹18,376 crore through the issuance of these bonds (₹42,800 cr in FY22). The interest rates offered on these bonds varied from 7.75-8.75%. Reason is ofcourse higher return compared to FD rates of 5.5-6.5% back then.
The ugly truth
The real casualty of the UBS-Credit Suisse deal were these bond holders. In all such cases of storm be it Yes Bank or Credit Suisse, these bond investors have sufferred the most. They got zilch on their investments. The problem is this may not be all. It could impact price of similar bonds issued by other banks. However, the exposure of Indian banks to AT1 bonds is relatively low. Private sector banks have an exposure of around 0-1% to AT1 bonds, while PSU banks have an exposure of 1-2%. Also, the spread between normal bonds and AT1 bonds have reduced now to just 80-150 basis points (100 bps = 1%) and are therefore not as attractive as they were 6 months ago. But ignorance is a bigger problem.
Retail investors typically take the word ‘bond’ for safety and assume that they get the money back on maturity. It is about time we understand the risk versus return tradeoff well before we put in our hard earned money.
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