Last Updated on Mar 24, 2021 by Manonmayi

Yes Bank crisis is not new to us and seems to have become an everyday topic in news. Early in March 2020, the RBI had permitted the write-down of Yes Bank AT1 bonds as part of the entity’s revival plan. While most investors including the depositors took this development as a breather, the AT1 bond holders themselves were not very happy about it.

In this article we’ll see:

Why do banks issue AT1 bonds?

What are AT1 bonds?

AT1 bonds features

Why do banks issue AT1 bonds?

Short for Additional Tier-1 Bonds, AT1 bonds came into being after global banks came together to formulate Basel III norms. Now, these norms aim at safeguarding the international banking system.

Even the collapse of a single bank can wreak havoc in an economy. Needless to say what the collapse of an entire banking system of a country or globe means. Recall the state of the US’ banking sector during the 2008 crisis. Bad, right? The fallout literally hit the entire globe. That’s why banks from across the countries are required to meet Basel III norms. So that the international banking sector stays resilient during financial and economic stress.

One of the most important Basel III norms is that a bank needs to raise capital internally before doing so externally via deposits and loans. As per this norm, Indian banks are required to maintain a total capital ratio of 11.5%. 8% of this is called Tier 1 capital, which essentially comprises of funds raised by the bank internally. Examples include are equity shares and reserves. The remaining 1.5% of the bank’s capital is called Tier 2 capital that comprises of hybrid instruments and supplementary reserves.

Tier 1 capital remains with the bank permanently or unless they decide to redeem them. Tier 2 capital can change hands. AT1 bonds form part of such Tier 1 capital and have unique features. Let us examine in detail.

What are AT1 bonds?

Banks issue AT1 bonds to ensure that they conform with Basel III norms. Additional Tier 1 Bonds or AT1 bonds are unsecured, perpetual and non-convertible bonds. Here’s more to help you understand how AT1 bonds work.

AT1 bonds features

Unlike a normal bond, the Additional Tier bonds have unique and specialized features as listed below.

AT1 bonds are perpetual and non-redeemable but have a call option

As mentioned before, AT1 bonds are perpetual, meaning you as an investor cannot redeem or sell these bonds. In fact, they don’t even carry a maturity date. However, these specialized bonds have a call option that allows the issuing bank to redeem them after 5 or 10 yrs. Meaning only the bank can decide whether to redeem the bonds or not and it will only go ahead under special circumstances. That said, a bank can redeem these bonds even before 5 or 10 years thanks to a particular clause in the agreement that allows the bank to repay AT1 bonds prematurely.

AT1 bonds have a fixed coupon rate but the bank can skip interest payment

Additional Tier 1 bonds carry a fixed interest rate called a coupon rate. The issuing bank pays interest at such a rate to the AT1 bond holders. Now, the bank can choose not to redeem these bonds instead, pay interest on them forever. But that’s not all. There’s a twist here as well. In case the capital ratio of the issuing bank falls below 8%, it can decide not to pay interest or pay only a part of it for a specific year. Speaking of part payment of interest, the bank can cut interest payout by 60%, 40%, and 20%, as per the terms. In addition, the bank can withhold interest payout in case it incurs losses and doesn’t have enough reserves to pay the investors. Meaning, the investors of such bonds will be left high and dry if matters take an unprecedented turn and can’t even sue the bank for default. Ouch!

The bank has a right to write-off or write-down AT1 bonds without investor’s consent

All said, the most notable feature of an AT1 Bond is the risk associated with the principal. In case the issuing bank’s Tier I capital falls below 8%, the RBI can ask it to write-off its outstanding AT1 bonds without even seeking the investors’ consent. That said, in the event where the issuing bank’s capital Tier 1 capital ratio falls below 6.125%, the bank can slash or write-down the face/principal value of the bond either temporarily or permanently.

Now that you have understood how AT1 bonds work, you may be in a better position to understand why Yes Bank did what it did. It wrote-down its AT1 bonds, thanks to which the bank reported an income of Rs 6,297 crore and a net profit of Rs 2,629 crore in Q4 of FY 2019-2020. And that is also why several investors of Yes Bank felt the pinch even though the entity declared positive results.

Aradhana Gotur