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Context: State Bank of India (SBI), the country's largest lender, recently issued additional tier-1 (AT-1) bonds worth Rs 10,000 crore at a coupon rate of 8.1%. However, the issue received a lukewarm response from investors, as only Rs 3,100 crore worth of bonds were subscribed.
- AT-1 bonds are a type of perpetual debt instrument that banks issue to shore up their capital base. They have no maturity date and can be called back by the issuer after a specified period. It carries higher interest rates than regular bonds, as they are riskier for investors.
- In case of a bank's failure or breach of certain capital ratios, the AT-1 bonds can be written off or converted into equity at the discretion of the Reserve Bank of India.
Additional tier-1 (AT-1) bond
- An additional tier-1 (AT-1) bond is a type of debt instrument that banks issue to raise capital. It is also known as a perpetual bond because it has no fixed maturity date and can be redeemed only at the discretion of the issuer. AT-1 bonds are considered to be hybrid securities because they have some features of both equity and debt.
Why is it important for Banks?
- AT-1 bonds are important for banks because they help them meet the Basel III norms, which are global standards for banking regulation.
- Basel III requires banks to maintain a minimum capital adequacy ratio (CAR), which is the ratio of their capital to their risk-weighted assets. Capital is divided into three tiers: tier-1, tier-2 and tier-3.
- Tier-1 capital is the highest quality and most liquid form of capital, consisting of common equity and retained earnings.
- Tier-2 capital is the second-highest quality and less liquid form of capital, consisting of subordinated debt and preference shares.
- Tier-3 capital is the lowest quality and least liquid form of capital, consisting of short-term subordinated debt.
- AT-1 bonds are part of tier-1 capital, but they are not as good as common equity, because they have lower priority in case of liquidation and they do not have voting rights. However, they are better than tier-2 capital, because they have higher interest rates and they can absorb losses on a going-concern basis.
- This means that if the bank's CAR falls below a certain threshold, the issuer can either write off the principal amount of the AT-1 bonds or convert them into equity. This way, the bank can avoid insolvency and continue its operations.
Some of these features are:
No maturity date
- AT-1 bonds do not have a fixed maturity date, which means that they can be redeemed only at the option of the issuer. The issuer can also call back the bonds after a certain period, usually five years, but this is not mandatory.
- AT-1 bonds offer higher interest rates than other debt instruments because they carry higher risks for investors. The interest rate is usually linked to a benchmark rate, such as the repo rate or the government bond yield, plus a spread that reflects the credit risk of the issuer.
Interest payment discretion
- The issuer has the discretion to pay or skip the interest payments on AT-1 bonds, depending on its profitability and capital position. If the issuer skips an interest payment, it does not constitute a default, but it affects its credit rating and reputation.
- AT-1 bonds have a loss absorption mechanism that allows the issuer to either write off the principal amount or convert it into equity if its CAR falls below a certain level. The loss absorption mechanism can be either automatic or discretionary, depending on the terms and conditions of the bond.
- AT-1 bonds are subordinated to all other liabilities of the issuer, except for equity. This means that in case of liquidation, they will be paid only after all other creditors are paid.
- AT-1 bonds help banks raise capital without diluting their equity or affecting their return on equity (ROE). They also help banks meet the Basel III norms and improve their CAR. They also provide flexibility to banks in managing their capital structure and interest payments.
- AT-1 bonds offer higher returns than other debt instruments, especially in a low-interest rate environment. They also provide diversification to investors' portfolios and exposure to the banking sector. They also benefit from tax advantages, as they are treated as equity for tax purposes.
- AT-1 bonds increase the cost of capital for banks, as they have higher interest rates than other debt instruments. They expose banks to regulatory risks, as they are subject to changes in rules and norms by the regulators. They create reputational risks for banks, as skipping interest payments or triggering loss absorption can damage their image and credibility.
- AT-1 bonds carry higher risks than other debt instruments, as they have lower priority in case of liquidation and a higher probability of loss absorption. They have lower liquidity than other debt instruments, as they have no maturity date and limited secondary market. They have higher volatility than other debt instruments, as they are sensitive to changes in interest rates, credit ratings and market sentiments.
- AT-1 bonds are a relatively new and innovative instrument in the Indian banking sector, which have both advantages and disadvantages for banks and investors. They have the potential to boost the capital base of banks and provide higher returns to investors, but they also entail higher risks and uncertainties. Therefore, the way forward for AT-1 bonds is to ensure that they are issued and invested in a transparent, prudent and informed manner, with adequate disclosure of their features, risks and rewards.
- The regulators, issuers and investors should also work together to develop a robust and liquid market for AT-1 bonds, which can enhance their efficiency and attractiveness.
Q. Which of the following statements is true about AT-1 bonds?
A) They have a fixed maturity date and pay a fixed coupon rate.
B) They have no maturity date and pay a variable coupon rate.
C) They have no maturity date and pay a fixed coupon rate.
D) They have a fixed maturity date and pay a variable coupon rate.
Explanation: AT-1 bonds are perpetual bonds, meaning they have no maturity date and can be redeemed only at the discretion of the issuer. They pay a fixed coupon rate, which is usually higher than other types of bonds to compensate for the higher risk.