AT1 bonds are risky but back on investor radar after YES Bank episode

AT1 bonds are hybrid instruments and pay a slightly higher rate of interest compared to similar non-perpetual bonds.

Wealthy investors and corporates are turning to additional tier-I (AT-1) bonds of large banks in search of higher yields in a declining interest rate environment.

Investors are now allocating as much as 10-20 per cent of their debt portfolio in such bonds, said experts, with bonds of State Bank of India and HDFC Bank traded frequently and preferred the most. ICICI Bank, Bank of Baroda, and Axis Bank are some of the other preferred banks.

AT-1 bonds pay a slightly higher rate of interest compared to similar, non-perpetual bonds. Banks have the right but not the obligation to pay back the principal amount after exercising a call option.
 

AT-1 bonds had fallen out of favour in March after the YES Bank episode. The rise in risk-off sentiment and concerns that such bonds could be written off led individual and institutional investors to dump such bonds. This led to a spike in yields. State Bank of India AT-1 bonds, for instance, traded at close to 10 per cent in April.

Higher yields combined with the decline in interest rates in other debt instruments, however, prompted investors to look at these bonds again.

With surplus liquidity in the system, overnight rates are hovering at 2 per cent and banks have cut deposit rates to 5 per cent and below. Last week, the RBI shuttered its 7.75 per cent savings bonds, cutting off another investment avenue for investors.

 

 

“What is driving investors is the high yield,” said Rohit Sarin, co-founder, Client Associates. 
 

“Yields on AT-1 bonds are higher than that given by non-convertible debentures and bank fixed deposits.”

Yields on such bonds have come off, too, in the past few days and are currently trading between 7.97 per cent and 8.86 per cent. At these yields, the post-tax returns for those in the highest tax bracket of 42.74 per cent would be in the range of 4.56 per cent-5.07 per cent.

“The decline in interest rates in other debt instruments has helped bring back the appetite for these bonds,” said Ajay Manglunia, managing director and head-institutional fixed income, JM Financial. He said the government's Rs 20 trillion relief package and the easing of lockdown restrictions had made investors hopeful that non-performing assets of banks would not balloon to the extent earlier envisaged.

Suresh Sadagopan, a financial planner, says all AT-1 bonds should not be painted with the same brush. He advocates bonds of SBI and Bank of Baroda to investors, considering their government backing. “It is highly unlikely that some of the trusted private sector banks will default but I would suggest that investors who want to play it safe stick with these two PSU names,” he said.

Investors should assess a bank’s balance sheet, its capital raising ability, pedigree and its common equity tier 1 capital, and other reserves from which AT-1 bonds will be serviced before investing, said experts.

The CET1 capital is a bank’s core equity capital compared with its total risk-weighted assets. 

“In light of the Covid-19 crisis, investors should assess the NPA situation closely. Will there be an equity dilution or equity infusion or any kind of erosion in CET1 ratio? There’re a lot of moving parts, and the margin of error is very small if NPAs shoot up significantly,” said a debt fund manager.