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High interest rates, in a scenario where we may possibly see peaking out soon, is seeing HNI investors locking into yields in novel fixed-income investments – especially longer-dated perpetual bonds sold by state-owned banks with higher yields than similar maturity government securities and popular mutual funds.

Market players see issuances topping Rs 30,000 crore this fiscal as HNI and Institutional investors lap these up with expectations of peaking interest rates.This comes after more than Rs 18,000 crore worth of AT1 bond (Additional Tier 1 Bond) sales in this financial year, with recent back-to-back issues from State Bank of IndiaBank of BarodaHDFC Bank and Bank of Maharashtra.

WHAT ARE AT1 BONDS

AT1 are a type of perpetual bonds (no redemption date hence perpetual – almost like equity) banks use to augment their core equity base. These bonds were introduced by the Basel accord after the global financial crisis to protect depositors. They do not have a maturity date and banks have a call option that permits them to redeem these bonds after a certain period, typically 5 years.

The issuer pays regular interest in form of coupon payment till the call date. Since these are like equity , perpetual in nature , yields on these are typically 100-150 bps higher than GSecs for the best issuers.

While a variety of entities may issue perpetual bonds, the most common ones in India are issued by banks to meet their Basel III capital norms bonds. In the case of bank AT-1 bonds,  banks can write off the principal in addition to not paying interest if they run short of capital or face bankruptcy- something that happened a couple of years ago with Yes Bank (writeoff of Rs 8500 crores). For an investor, this feature and the eternal nature of these bonds add to the risk; but they usually fetch higher yields than other debt instruments.

While the principal amount in such bonds is never really due for repayment, issuers do attach a call option. So, at the end of a specific term, say five or 10 years from the issue date, the issuers can buy back the bonds from the investors.The issuer may call or redeem the bonds if refinancing may be done by them for the issue at a cheaper rate, especially when interest rates are falling.

Investors can also use the secondary market as a means of exit in the case of traded perpetual bonds.

 

 

Source of Images: Corporate Finance Institute, Moneycontrol

Rising Popularity

The Government over the years has shown immense support towards developing the market to ensure that even in the most difficult times AT1s (additional Tier I) issued by PSU Banks have fared well

Recently, in CY 2022 , the popularity of these bonds has increased . AT1 bonds issued by Punjab National Bank and Canara Bank recently were lapped up by Banks, Institutions, Corporate Treasuries and HNIs. These issues were worth Rs 2,000 crore each.

All PSU banks have thus far either paid their obligations on time like coupon servicing and always exercised the call at option date. This has allowed investors to draw a lot of comfort and they have been participating as it gives better returns.

RISKS

The Interest and principal default risk in PSU Bank perpetual bonds (unlike others) are somehow curtailed by GOI ownership. You may find comfort in Nationalised banks being guarded by the government of India. The recent capitalization announcement in Dec 2017, of Rs 2.11 lakh crore in banks by the government is an example where the government may pitch in to support the banking system and therefore curtail risk.

Credit Risk- : AT1 bonds are capital instruments  and not exactly borrowings and in case of insolvency proceeding hierarchy, they are behind deposits, borrowings and Tier II bonds. This essentially means that investors in these bonds will be compensated after others are taken care of in the hierarchy, in case something were to go wrong.

Besides this, the coupon payment on these bonds depends on the current year profitability of the issuing bank. If the bank is not in profits or does not satisfy the minimum capital adequacy requirement as laid down by RBI then it has the option of not paying the interest of that particular year.

Liquidity Risk – These bonds do not have any maturity date. You cannot sell it back to the issuer. The only liquidity available is through the secondary market which again depends on the demand of the bonds and Interest rate scenario.

Interest rates risk –Any rise in general interest rates will impact negatively to the price of your bonds and conversely, fall in rates will impact you positively. But all this will only impact the price of the bonds and not the coupon rate on which you have invested. So, if you stay invested till the call date, then you will not be impacted by Interest rate movements. Assuming of course that the call option is exercised which is most likely for PSU Banks. In Recent times, in 2019, Andhra Bank chose to revisit its call option exercise after their board initially annnounced a non exercise and the government had to step in to calm markets by asking Andhra Bank to reconsider this.

Credit risk/Default risk – As per the terms of these bonds interest payments are to be made through the current year profits and if that does not suffice then from Feb 2017 RBI has allowed dipping into Reserves and surplus. But in case of the bad financial state of the banks, and non-compliance of RBI capital adequacy norms, then the payment towards the interest as well as capital may be fully or partially written off at the option of RBI.

Taxation

The Annual coupon from the perpetual bonds will be added to the total income of the investor and taxed as per the Income tax slab one falls in.But if the bond gets sold in the secondary market and Investor makes long-term capital gain (after holding period of 1 year), then the LTCG will be taxable at 10% (without Indexation)

Our View 

We are today at the cusp of what may soon be a peaking of rates – either because of liquidity returning to emerging markets (relative growth picks up esp if China resumes production post its harsh Covid steps) OR at the other extreme, the western nations stroll into a semi recessionary situation. In either case, its possible that long bond holders will benefit from the impact of declining market yields and perpetual bond holders will have a similar gain in case secondary markets are chosen.

For those who wish to hold the bonds to first call date, for the same reasons as above, we believe the banks are likely to exercise the call options as market yields would be lower than current yields.

Given the backing of the government and the high yields currently (Secondary Yields on PSU Banks in range of 8.5%-8.75% ), we do believe they have a place in debt oriented large investors (Minimum Size: Rs 1 Cr) relative to deposits and mutual funds and of course with capped exposures to these instruments at about a 10%-15% allocation overall. Trusts, Charities and corporates managing long term corpuses for employees may also find these an interesting investment.

Do write in to us at [email protected] for more information on how we can help you improve yields on fixed income portfolios or to participate in the issues of any such bonds.

Read RBI Circular at https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=12173&Mode=0

 

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