Perpetual bonds issued by banks as part of the Additional Tier 1 (AT1) requirements find takers in institutional investors as well as individuals (high net-worth individuals and the mass affluent segment). They, however, face the issue of early callback, as has happened with some public sector banks. But there is an investment case in AT1 perpetual bonds—there is a higher return that can be availed of, subject to certain risks.
There are three risks these bonds face: a) Coupon can be paid only out of profit and reserves, so it may not be paid if the bank is deep in losses; b) in the unlikely event of the bank winding up, holders may have to share the losses like equity shareholders; and c) the bonds are perpetual and the ‘maturity’ based on which these are traded in the secondary market is the call option, which may or may not be exercised. These risks are known because the credit rating reflect it. The highest credit rating for AT1 perpetual bonds is AA+, even for banks that have a credit rating of AAA for their conventional bonds, factoring in the risks mentioned above.
Let us look at these risks from a practical perspective, i.e. the likelihood of the theoretical risk occurring. Banks are the pillars of the Indian financial system and anything untoward would lead to a systemic crisis, which the government or the Reserve Bank of India (RBI) would like to avoid or manage in some manner. For nationalised or public sector banks, there is implied support from government ownership. In case of leading private sector banks, the fundamentals are relatively better, there is robust supervision from RBI and there is public scrutiny as these are listed.
Even in the case of premature call-back (prior to the scheduled call date) of bonds from public sector banks that were put under prompt corrective action (PCA), there is a positive aspect. There were doubts on the coupon-servicing ability of these banks and to avoid the crisis of confidence, the bonds were called back prematurely. Though this is not a one-to-one correspondence, in a way it instils confidence that the call option on AT1 bonds, as and when it falls due, will be exercised. We are yet to come across the scheduled call date of any AT1 bond, but already a host have called back, starting with Central Bank of India in February 2017. There is no put option in these bonds, hence the call option is significant.
After the risks, let us look at the returns. Any risk has to be compensated by higher returns and as long as there is adequate compensation, there is a case for investment. This is a calculated risk. The yield-to-maturity (YTM) on these bonds, based on which trades take place in the secondary market, as distinct from the coupon or interest rate, ranges from 9% to 10% for the relatively better public and private sector banks. The call option on these bonds is about 3-4 years from now, which means that these are traded as 3-4-year maturity papers, though these are perpetual, assuming the call option will be exercised. For benchmarking purposes, conventional bonds of these banks, of comparable maturity, rated AAA, would be in the range of, say, 8.5-9.5%. The differential in yield is 0.5% or higher. This is adequate compensation for differential of one notch in credit rating and marginally higher risk.
Another relevant aspect is that the 11 public sector banks under PCA that have called back their AT1 perpetual bonds prematurely, may or may not come to the market again as they may satisfy the requirement of tier I capital ratio requirements through equity shares. At least in the immediate future, it is unlikely that they will hit the market as there are question marks on their service ability. That being the case, supply of bonds in this segment would be lower to that extent, making it a case for investment in higher quality banks. Better quality refers to public sector banks that are unlikely to come under PCA, and leading private sector banks.
There may be further primary issuances, from non-PCA public and private sector banks. The return (YTM) on these bonds will be a function of interest rates in the market at that point of time. Though these will add to the existing stock of this category of bonds, there is adequate demand from institutional investors as well as HNIs. Liquidity in AT1 perpetual bonds is adequate; if you want to dispose of your holdings for cash flow requirements or to book profits, you will find a buyer without much sacrifice on yield. Note that these bonds are still not traded in retail lots; they are traded either in the wholesale (institutional) market or in the HNI or mass affluent segment.
Joydeep Sen is founder, wiseinvestor.in