The way to make AT1 bonds attractive again is to clarify the insurance-linked role that sets them apart from pure debt, revert to valuation as per the time period of call options, and vastly improve banking supervision via enhanced management of banking data.
According to a report in the Economic Times, mutual funds are less than enthusiastic about buying Additional Tier 1 (AT1) bonds issued by banks. The share of AT1 bonds in mutual fund assets has come down to 0.45 per cent from 2.53 per cent in 2020 when the writing off of Yes Bank’s AT1 bonds soured investor appetite for this category of bonds.
Litigation is pending in the Supreme Court on the validity of the Reserve Bank of India (RBI)-backed decision to wipe out the AT1 bonds even as equity was retained intact. The way to induce better investor interest in these vital instruments is to improve banking supervision and regulation and remove concerns over valuation norms, without giving in to the populist demand to treat AT1 bonds as regular debt with special rights over equity.
The Indian development mirrors the sentiment in Europe after the Swiss banking regulators wiped out the entirety of AT1 bonds of troubled Credit Suisse before its shotgun marriage to rival UBS. In the immediate aftermath, UBS’s AT1 bonds saw their yield spike to 16 per cent, but the yield has come down to 12 per cent now, which is still way too high. But the picture is different in Japan, where the appetite for AT1 bonds seems robust.
Mitsubishi UFJ Financial Group, Japan’s leading bank, will issue 330 billion yen ($2.3 billion) in AT1 bonds, roughly triple the amount considered earlier, reports Reuters, in response to growing investor demand. The yield is expected to offer a 1.65-1.66 per cent spread over Japanese government bonds.
In India, the cited reason for investor aversion to AT1 bonds is Sebi’s new valuation norm for these instruments, apart from the banking regulator’s support for giving equity superior rights over AT1 bonds when it comes to tiding over a banking collapse.
Sebi wants AT1 bonds to be valued like 100-year bonds, whereas, earlier, valuation was benchmarked against call options on the bonds. There does not appear to be any compelling reason to abandon this former benchmarking practice, and returning to the practice would be a pragmatic step towards reviving interest in AT1 offerings.
AT1 bonds form a capital buffer that is intended to absorb the loss in case the bank stumbles. In other words, AT1 bonds are, in principle, insurance-linked securities, rather than regular debt. These are best considered close cousins to Catastrophe bonds or Cat bonds for the financial sector.
Cat bonds are typically sponsored by an insurance company or a re-insurance company to transfer the risk of having to make a payout against a disaster, on which insurance has been sold, to a larger society via bonds that offer a yield superior to what the market offers. These bonds would be held in a Special Purpose Vehicle that would invest the proceeds in low-risk fixed-income instruments such as government bonds, and also receive a premium payment from the sponsor, which builds the premium to the market yield that the Cat bond pays out.
In case the disaster, against which insurance has been sold, does occur, the principal and interest payments of the bonds could be deferred or written off in full or in part, protecting the sponsor. For the investor in the bonds, the instrument is a high-risk but high-reward fixed-income option that has the advantage of not being linked to business cycles and is worth the deployment of a tiny slice of an investment corpus that is diversified across sectors to minimise risk and maximise returns.
Insulation Against Insolvency
AT1 bonds are intended to absorb the loss the bank makes, offering insulation against insolvency. These are not meant to supplement the funds at the disposal of the bank for generating revenue. At the time of issuance, it is made clear that the bonds could be written off in full or in part in case of distress, and it is to compensate for this risk that the bond offers superior yields. Investors cannot grab that premium yield and cry foul when the risk that underlies the interest premium does materialise.
Creating an AT1 capital buffer is a mandatory requirement for banks. But if investors baulk at buying AT1 bonds, what is the solution? You could induce greater risk-taking by offering ever higher yields, or you could lower the risk premium by means of superior management, underwritten by better banking supervision.
India has an advantage over the rest of the world when it comes to financial data. The Account Aggregator framework operationalises the consent layer of financial transactions enabled via the India Stack of Application Programming Interfaces (APIs) created to enable diverse use of Aadhaar, the unique identity issued to all residents. Thanks to this, it is possible for accountants and the bank supervisor to access real-time financial transactions of the bank, provided the bank gives its consent.
With such data at hand, bank supervision becomes far simpler. For example, the circular lending that enabled fund diversion while evergreening a bunch of loans issued among a group of lending institutions, which formed the basis of the IL&FS fiasco of 2018, could have been caught early on, provided the auditors/supervisors had the needed analytics tools and skills.
The way to make AT1 bonds attractive again is to clarify the insurance-linked role that sets them apart from pure debt, revert to valuation as per the time period of call options, and vastly improve banking supervision via enhanced management of banking data. It is not a sensible option either to give in to populist pressure to treat AT1 bonds as pure debt or to pay ever-rising risk premia on these bonds.
The article was first published in The MoneyControl as How to Burnish AT1 bonds that have lost their sheen on May 31, 2023.
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