Just about two years ago, additional tier-1 bonds, which are a means of augmenting core equity for banks, were a pariah in Indian financial markets as a crisis in YES Bank caused enormous losses for those who had invested in these debt instruments.
If the aggressive pricing of AT-1 bonds issued by banks over the past couple of months is anything to go by, it seems that markets have shrugged off the risk aversion sparked by the YES Bank debacle and extended a warm welcome to these securities.
Since July, seven banks have raised funds totalling Rs 18,376 crore through the issuance of these bonds. The cut-off rates – or the interest paid by banks – have plummeted since Punjab National Bank kick-started the issuance spree on July 4. Banks raised a total of Rs 42,800 crore via AT-1 bonds last year.
While PNB shelled out 8.75 per cent for AT-1 bonds worth Rs 2,000 crore, State Bank of India on Wednesday issued Rs 6,872 crore of such bonds at a rate of 7.75 per cent. A day prior to that, HDFC Bank sold AT-1 bonds worth Rs 3,000 crore at a rate of 7.84 per cent.
The fall in AT-1 bond cut-off rates has, of course, coincided with a decline in government bond yields, which are the key pricing benchmarks for credit in the economy. However, the shrinking of the spreads between benchmark securities and the rates set for AT-1 bonds indicates the degree of aggression investors have shown to acquire these instruments.
In July, when Canara Bank sold AT-1 bonds worth Rs 2,000 crore at a rate of 8.24 per cent, the cutoff was deemed unusually low at the time. The spread between the state-owned bank’s debt and bonds issued by Nabard narrowed to abut 85 basis points, as against a spread of nearly 200 bps the last time Canara Bank sold AT-1 bonds in March.
Nabard’s bonds are used as a pricing reference for corporate debt.
Since July, the spreads have shrunk to a much greater extent–the bonds issued by SBI and HDFC Bank were 55-65 basis points lower than prevailing five-year levels for benchmark five-year corporate debt and a mere 25-35 bps lower than those for 10-year debt.
SBI and HDFC Bank’s bonds have a call option after five years. Since July 4, yield on the five-year government security has declined 21 bps while that on the 10-year paper has fallen 31 basis points as global crude oil prices have cooled, easing concerns over elevated inflation.
Even as the appetite for AT-1 bonds has returned, the investment landscape stands significantly altered following a regulatory overhaul. The key factors that have contributed to the recent demand for these instruments include lower supply than last year, rating upgrades for banks and interest from high-net worth individuals.
Analysts do not expect the issuance of AT-1 bonds this year to exceed Rs 20,000 crore by much.
Replacement demand amid the exercise of call options by highly-rated banks has also pushed appetite for AT-1 bonds. Another factor that has garnered the interest of investors is the fact that AT-1 bonds, which are much less liquid than government bonds, were spared the bout of turbulence that the sovereign debt market witnessed in the beginning of the current fiscal year.
In June, yield on the 10-year government paper climbed to three-year highs as the Reserve Bank of India ramped up rate hikes.
“AT1 bond yields have not risen much from last year, compared to vanilla corporate bonds or GSecs and while some market observers are critical of this, paradoxically this outperformance of lower MTM losses may have given some HTM investors additional comfort and encouraged them to invest again,” Shameek Ray, ICICI Securities Primary Dealership’s head of debt capital markets said to Business Standard.
“The Corporate / HNI / Retail investor is investing across various instruments including MLDs (market-linked debentures), target funds, vanilla corporate bonds, SDL (state-development loan), gilts, guaranteed return insurance policies and AT1 bonds and the diversification benefits of AT1 Bonds along with shorter calls and higher rates is driving the end investor demand in AT1 bonds,” he said.
According to Ray, following changes in regulation, investors are now exhibiting a greater degree of sophistication and have realised that the AT-1 bonds issued by larger banks are safer than they were earlier.
While the Sebi’s new norms on revaluation of AT-1 bonds have shrunk the appetite of mutual funds for these instruments, insurance companies have been displaying interest due to a specific regulatory relaxation.
“On the insurance side, they are quite gung-ho about this and are subscribing because there’s been a change where they’ve been allowed to subscribe to bonds of companies which have not paid dividends in the last three years. That was earlier a restriction which has now been taken away,” Karan Gupta, director of financial institutions, India Ratings and Research said.
“I think there’s a fair amount of investor interest in the instrument. Mutual funds are still staying away from it given the change that the SEBI has brought about. But, there is a fair amount of interest that we are aware of from pension funds and from family offices,” Gupta said.
With improvements in key bank metrics rekindling confidence in their issuance of AT-1 bonds, investors have been all the more drawn to these instruments by the fact that they offer better returns that tier-2 bonds and fixed deposits.
Lower returns and a greater degree of volatility in equity markets than the previous year have also drawn investors to relatively high-yielding AT-1 instruments.
There are those, however, who have raised concerns about the nature of the instrument and referred to the experience of investors who lost around Rs 10,000 crore due to a write- down of YES Bank’s bonds.
Some analysts have pointed out that while banks would likely exercise call options and redeem AT-1 bonds during periods of higher profitability, they could avoid doing so during adverse scenarios. This could result in investors foregoing coupon payments on these instruments.
“Going ahead, the test will of course come from demand supply, i.e. whether lower supply this year will continue to face higher demand, keeping rates and spreads compressed,” Ray said.