Icra warns AT1 bond investors of higher risks, esp on exits

The rise in Additional Tier-1 (AT1) bond issuance by banks will reduce the pressure on government finances on recapitalising the NPA-saddled state-run lenders, rating agency Icra said, though warning investors about higher risks associated with the instrument.
"In case banks are able to raise sizeable capital by way of AT1 bonds, it could potentially reduce the quantum of support that the government would need to provide for the public sector banks," it said in a note today.
The report said state-run banks have raised around Rs 25,000 crore through Basel-III-compliant AT1 bonds, which get factored in as part of core equity now, in the last few years, which includes Rs 8,180 crore raised in this fiscal alone.

For the banks which are facing lower valuations which make it difficult to raise money from the capital markets, this new instrument will help, the agency said.
It said nearly 40 per cent of estimated tier-I capital requirement of up to Rs 2.1 trillion over the next two years can be met by the state-run banks through this instrument. But it warned investors about the risks associated with the instrument despite the higher coupons they offer.
"Though the 1.50-2 per cent higher yields on such papers are attractive, investors should also keep in mind that the risks associated with such instruments are higher and the rating transition could also be sharper compared to other debt instruments of the same bank," it said.

The report said these bonds are perpetual in nature and the option to repay lies only with the issuing bank while investors have to depend on the secondary market for an exit.

Drawing attention to heavy losses in recent quarters, it said the risks for investors have increased because of the losses which deplete their distributable reserves.
"Coupons of AT1 from revenue reserves are subject to the issuing bank meeting minimum regulatory requirements for CET1, tier 1 and total capital ratios at all times," it said.
The report also said the coupon on AT1 is paid out of distributable items - from annual profits or in case of loss, in a year from revenue reserves or credit balance in profit and loss account. The agency, however, said despite these risks, there has been an increased appetite shown by investors for the instrument in the recent past.

Unlike in the past where the arrangers had to hold on to these bonds for a longer-than-expected period on account of low investor appetite, this time they have been able to place a sizeable amount of the issuance with the investors, it said, clarifying that this is based on anecdotal experience.
These bonds offer higher coupons of 9-11.5 per cent, which is significantly higher compared to senior bonds which offer 7.5-9 per cent, for ratings between AAA and A+ for tenures of 5-10 years, it said.