Contributed by Manya Sharma

Introduction

The Securities and Exchange Board of India (“SEBI”) issued new valuation norms for Additional Tier 1 (“AT1”) Bonds to mutual fund houses, to treat these bonds as 100-year papers for valuation purposes. This drastic change came as an aftermath of the Yes Bank’s complete write-off of AT1 bonds worth 8,000 crores. SEBI’s new guidelines coupled with the recent Credit Suisse write-off, has caused great uncertainties in the AT1 bond market globally.  The feature of a complete write-down is unique to these bonds and has always been present. However, it has become a great cause for concern in the last few years, considering the trend of complete write-downs being followed by various regulatory bodies around the world.

This article aims to understand the impact of recent write-offs and the approach of the banks and regulatory authorities towards AT1 capital, on the AT1 bond market and accordingly, propose possible solutions to gain back the investors’ confidence.

What are AT1 Bonds?

The tier 1 capital of any bank has two components, namely the Common Equity (CET-1) and Additional Tier 1. AT1 capital is raised by banks, by issuing AT1 bonds to the public – AT1 is a hybrid instrument that can be converted to equity upon the occurrence of a trigger event. An AT1 bond has both a conversion as well a write-down clause. Either of these clauses can be exercised by the banks, depending on directions by the government regulator. The conversion clause provides for the conversion of AT1 Bonds to equity instruments and on the other extreme, when the write-down clause is exercised the bonds are used for loss-absorption and are subsequently written down permanently.

Given that their inherent nature is loss-absorption when banks reach a ‘point of non-viability’, they have the option to exercise either of these clauses. The option of exercising either clause can be pre-determined for as and when the situation arises or it can be discretionary as per the government regulator, which poses higher risk and uncertainty to investors.

In India, if banks reach the point of non-viability, the Reserve Bank of India (“RBI”) has the power to direct which of the two clauses are to be exercised, depending on the circumstances. In most cases, banks prefer to use the write-down option instead of conversion to avoid dilution of equity. In the cases of both Yes Bank and Credit Suisse, the respective regulatory authorities exercised the clause for complete write-down as part of their restructuring plans, after the banks reached the point of non-viability.

SEBI’s Guidelines

In 2021, SEBI, considering the special features and comparatively risky nature of these AT1 instruments, released a circular limiting the investment and changing the valuation norms for the AT1 bonds. As per the new valuation guidelines these bonds, perpetual in nature, are to be treated as 100-year papers for valuation. Treatment of perpetual bonds as having 100 years of maturity significantly reduces the value of these bonds and increases the chances of bondholders having to bear the loss due to write-offs. Treating AT1 bonds as 100-year papers has affected the exceptionally high yields offered on these bonds. Earlier, the call option on AT1 bonds was usually exercised by banks at regular intervals of 5 to 10 years. Longer maturity periods increase bondholders’ risk of being faced with a situation of write-off.

Additionally, mutual fund houses may resort to redemption of AT1 bonds and engagement with other debt instruments to maintain liquidity which will cause disruptions in the corporate bond market. As mutual fund houses are the primary investors in AT1, such restrictions on them may shift the burden of capital raising on the government. This goes contrary to the purpose for which AT1 instruments were formed, which was to avoid government bail-outs for banks in distress.

Implications of write-off

With the new valuation norms in place, banks are finding it increasingly difficult to raise AT1 capital. The State Bank of India (“SBI”), the country’s largest lender, released its third issue of the year for AT1 bonds in July 2023. While both issues in the same year before April 2023 were oversubscribed, this time it was only able to raise about 30% of the total amount issued. Such a lukewarm response to SBI’s issue has also prompted several other public sector banks to rethink their capital-raising options in the present market conditions.

This disruption in the AT1 market is not restricted merely to India. Recently, the $17 billion Credit Suisse write-off by the Swiss regulators, has caused ripple effects in bond markets all over the world. In the Credit Suisse write-off, the main contention of the investors was regarding the priority given to the equity shareholders at the cost of bondholders, ignoring the traditional hierarchy followed by banks for loss absorption. In the Yes Bank fiasco, the write-off was approved as part of RBI’s restructuring plan however, the investors were not made aware of the write-down clause initially, while the issuance of these AT1 bonds. Therefore, due to lack of full disclosure or risks, the move by regulatory authorities led to investors being in a disadvantageous position.

Owing to such frequent instances with AT1 bondholders, the concerns about volatility of AT1 Bonds have surfaced and investors’ appetite for AT1’s high yield has come to a near halt. Bid prices of banks like – HSBC, Deutsche Bank, UBS, and BNP Paribas are falling sharply and banks globally are finding it difficult to raise tier 1 capital and fulfilling their obligations under Basel III norms.

The Way forward for the AT1 Market

There are various measures that banks, regulatory authorities, and investors can take to potentially revive the AT1 bond market. Full disclosure of potential risks and mitigation strategies to avert their structural and financial failures will allow investors to make better-informed decisions. Moreover, banks having strong capital ratios should exercise their call option and redeem their AT1 bonds, in order to instill confidence in the market. Recently, supervisory authorities have approved UniCredit’s decision to redeem its $1.38 billion AT1 bonds with the approval of regulatory authorities, considering its strong position to prop up investor confidence.

Banks may also resort to the premortem strategy. As the name suggests a premortem strategy is undertaken before the issuance of AT1 Bonds, in which the banks list out the potential systematic or unsystematic risks that can reduce the capital ratios and trigger the write-off clause. The use of the premortem strategy will allow banks as well as investors to be aware of potential risks and events that may arise which can trigger the write-off, leading to greater transparency. It will also narrow the investor base of AT1 bonds only to experienced institutional investors rather than retail investors, who are attracted by high yields and completely unaware of the higher risks.

Lastly, inspiration can be drawn from the U.S.’s preferred securities option. Unlike the European model, U.S. Banks issue preferred equity in place of the European Contingent Convertible Bonds (“CoCos”) and AT1, which classifies as tier 1 capital but does not have a compulsory write-down clause in case of trigger event. Discretion to write down or convert these ‘U.S. Preferred’ lies with the regulatory authorities as opposed to the European model where there is compulsory write-down at a predetermined level of capital ratios. Vesting banks with such discretion may allow the exploration of some more agreeable loss absorption strategies.

Conclusion

AT1 bonds have been a great attraction among investors owing to their exceptionally higher yields, however recently, after being exposed to the downside of these bonds, even experienced investors have become wary of AT1. One after another Yes Bank and Credit Suisse’s write-offs have changed the attitude of the market towards AT1 Bonds. This shake in confidence stems from uncertainties, lack of clarity and uniformity in the hierarchy to be followed for loss absorption, and wide discretionary powers with the regulatory and supervisory authorities as they are seen prioritizing shareholders at the cost of bondholders. However, the AT1 market is not beyond revival, with appropriate measures and necessary precautions like redemption of bonds by banks having strong capital ratios, resorting to premortem strategy and taking inspiration from the U.S. mechanism of CoCo Bonds, the AT1 bond market can re-gain its momentum.