AT1 Bonds : Decoded

Description

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Context:

The Bombay High Court quashed the write-off of Additional Tier-1 (AT1) bonds worth Rs 8,400 crore issued by Yes Bank Ltd, bringing relief to investors.

What are AT1 bonds?

AT1 bonds are unsecured bonds that have perpetual tenors.
In other words, these bonds, issued by banks, have no maturity date.
There is a call option, which can be used by the banks to buy these bonds back from investors.
Call options allow banks to redeem them after five or 10 years. But banks are not obliged to use this call option and can opt to pay only interest on these bonds for eternity. Two, banks issuing AT-1 bonds can skip interest payouts for a particular year or even reduce the bonds’ face value without getting into hot water with their investors, provided their capital ratios fall below certain threshold levels. These thresholds are specified in their offer terms.
Three, if the RBI feels that a bank is tottering on the brink and needs a rescue, it can simply ask the bank to cancel its outstanding AT-1 bonds without consulting its investors. This is what has happened to YES Bank’s AT-1 bond-holders who are said to have invested ₹10,800 crore.

Purpose of AT1 Bonds:

AT 1 bonds are typically used by banks to bolster their core or tier-1 capital.

Tier 1 Capital vs. Tier 2 Capital: An Overview

A bank's capital consists of tier 1 capital and tier 2 capital,

Tier 1 capital is a bank's core capital and includes disclosed reserves—that appears on the bank's financial statements—and equity capital. This money is the funds a bank uses to function on a regular basis and forms the basis of a financial institution's strength. Tier I capital is a bank's highest quality capital because it is fully available to cover losses.
Tier 2 capital is a bank's supplementary capital. Undisclosed reserves, subordinated term debts, hybrid financial products, and other items make up these funds.

A bank's total capital is calculated by adding its tier 1 and tier 2 capital together.

Components of Tier 1 Capital

Tier 1 Capital = Common Equity Tier 1 Capital + Additional Tier 1 Capital

1. Common Equity Tier 1 (CET1) Capital – CET1 capital is the core equity capital of the bank and includes shareholders equity, retained earnings, and accumulated other comprehensive income of the bank.

2. Additional Tier 1 (AT1) Capital – AT1 capital includes certain contingently convertible and perpetual debt of the bank since they provide going concern capital to the bank.

Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the bank's tier 1 capital by its total risk-weighted assets (RWA).

In India, one of the key new rules brought in was that banks must maintain capital at a minimum ratio of 11.5 percent of their risk-weighted loans. Of this, 9.5 percent needs to be in Tier-1 capital and 2 percent in Tier-2. Tier-1 capital refers to equity and other forms of permanent capital that stays with the bank, as deposits and loans flow in and out.

These bonds were introduced by the Basel accord after the global financial crisis to protect depositors. The bonds act as buffers for banks in times of stress and are perceived to be safer than equity shares.
While AT1 Bonds offer higher returns to investors compared with other debt products, AT1 bonds are considered high risk because, in case of an institutional failure, the banks are allowed to stop paying interest and, if needed, write off these bonds.
AT1 bonds are subordinate to all other debt and only senior to common equity. Mutual funds (MFs) were among the largest investors in perpetual debt instruments.

How are these bonds different from other debt instruments?

These bonds are perpetual in nature — they do not carry any maturity date. They offer higher returns to investors but compared with other vanilla debt products, these instruments carry a higher risk as well.
If the capital ratios of the issuer bank fall below a certain percentage or in the event of an institutional failure, the rules allow the issuer to stop paying interest or even write down these bonds, as happened in the Yes Bank case.
These bonds are subordinate to all other debt and senior only to equity.

What did Yes Bank do?

A SEBI probe found that the bank facilitated the selling of AT1 bonds from institutional investors to individual investors.
It found that during the process of selling the AT1 bonds, individual investors were not informed about all the risks involved in the subscription of these bonds.
The SEBI investigation also found that Yes Bank represented these bonds as a ‘Super FD’ and ‘as safe as FD’ to the investors.

What led to the write-off?

Yes Bank, which was on the verge of collapse, was placed under a moratorium by the Reserve Bank of India in March 2020 and a new management and board were appointed as part of a rescue plan.
RBI allowed a write-off of Rs 8,400 crore on AT1 bonds issued by Yes Bank. It was a part of a restructuring plan to rescue YES Bank.
Write-Off is when the loan is no longer counted as an asset and money invested in the bank is no longer counted as the liability of the bank.

Implications

The Bombay High Court had allowed the bondholders' petition against the write-off.
Advocates appearing on behalf of the bondholders argued that the write-down of AT1 bonds could only have been done if the bank went into liquidation. The write down of AT-1 bonds affected the legal rights of a class of citizens.
Quashing the write-off of Bonds will benefit all bondholders, including 63 Moons Technologies, which held bonds worth Rs 300 crore.
And now the decision to write off the AT1 bonds has been quashed. This is a relief to the investors.
Individual bondholders, most of whom were senior citizens, can finally find some justice through this judgment of the Bombay High Court.