AT-1 Bonds

CONTEXT: The underwhelming subscription to State Bank of India (SBI)’s additional tier-1 (AT-1) bond issue

WHAT ARE AT1 BONDS?

• These are a type of unsecured, perpetual bonds that banks issue to improve their core capital base.
• The money raised through these bonds is kept aside as a shock absorber by the bank.
• They have a call option, which can be used by the banks to buy these bonds back from investors.
• These bonds were created in the wake of the 2008 financial crisis to absorb the losses.
• These bonds are also called contingent convertible bonds or CoCos.
• These bonds are also mandatory under Basel=III norms.
• The banks must maintain capital at a minimum ratio of 11.5 per cent of their risk-weighted loans. Of this, 9.5 per cent needs to be in Tier-1 capital. AT1 bonds fall under this type of capital.
• These bonds are long-term and do not carry any maturity date. Because of a higher risk, they offer a higher yield.
• Regulation: In India, AT-1 bonds are regulated by the Reserve Bank of India (RBI).

KEY FEATURES OF AT1 BONDS INCLUDE

• Perpetual Nature: AT1 bonds generally have no fixed maturity date and are perpetual in nature. This means that the issuer (the bank) is not obligated to redeem the bonds at a specific date. Instead, the bonds may remain outstanding indefinitely, subject to certain conditions.
• Coupon Payments: AT1 bonds pay a fixed or floating coupon to investors at regular intervals (usually annually or semi-annually). However, the issuer has the discretion to defer coupon payments if it faces financial difficulties or breaches certain regulatory capital thresholds.
• Loss Absorption Mechanism: One of the key features of AT1 bonds is their loss absorption mechanism. If the bank faces financial distress, the bonds can convert into common equity or be written down, meaning that the bondholders may suffer losses on their investments. This loss-absorption feature provides an additional layer of protection for the bank’s other creditors and depositors.
• Call Option: Some AT1 bonds may have call options that allow the bank to redeem the bonds at a specified price after a certain period. The call option gives the bank flexibility in managing its capital structure.
• Regulatory Requirements: AT1 bonds are subject to regulatory requirements set by banking authorities, such as the Basel Committee on Banking Supervision.
  • These requirements dictate the conditions under which coupon payments can be deferred or the bonds can be converted or written down.
• High Yield: Due to their higher risk profile and loss-absorption features, AT1 bonds typically offer higher yields compared to other debt instruments issued by the same bank.

AT1 BOND AND MARKET SCENARIO

• SBI’s AT1 Bond Issue: SBI’s recent AT1 bond issue faced underwhelming subscriptions, raising concerns about market sentiment and fund-raising for other PSU banks. SBI managed to raise only a fraction of the issue size, and the coupon rate offered did not seem to attract investors.
• Market Perception: The coupon rate offered by SBI was 8.1 per cent, which was higher than the yield on the 10-year benchmark g-sec by 91 basis points.
• Impact on PSU Banks: The underwhelming response to SBI’s AT1 bond issue may lead other PSU banks to adopt a cautious approach.
  • They may wait and assess market conditions, consider offering higher rates, or delay their fund-raising plans to gauge market appetite.
• Prevalent Market Environment: The current market environment is witnessing overcrowding in the long-tenure space, which may lead to a pricing mismatch and challenge demand for AT1 bonds.
  • Higher interest rates are also influencing investor expectations.
• Policy Recommendations: To make AT1 bonds more attractive to investors in the current market, market participants suggest a premium of at least 15-20 basis points over current rates.