BL Explainer. What the Yes Bank AT1 bonds fiasco is all about

What are AT1 bonds? How are they different from conventional corporate bonds?

AT1 bonds, short for Additional Tier 1 bonds, are a class of bonds issued by banks. After the global financial crisis of 2007-08, it was felt that banks ought to operate with a higher proportion of their own, permanent capital as opposed to borrowed capital. This permanent capital is termed as Tier 1 capital.

Now, to shore up their Tier 1 capital, banks were allowed to raise a special class of bonds known as AT1 bonds from investors. AT1 bonds, like other bonds, pay regular interest. But they do not have a maturity date, as they are a permanent part of the bank’s capital, akin to equity.

In practice, however, banks do offer a call option on these bonds after five years, when they may or may not redeem them. Apart from having no maturity date, AT1 bonds are different from vanilla bonds in other respects too.

The bank issuing them has the discretion to either reduce or completely skip their interest payout, if it is making losses or at risk of falling short of capital needs. If the RBI believes that the bank is becoming short of capital or unviable to operate, it can direct the principal on these bonds to be written off too. This makes AT1 bonds far riskier than vanilla corporate bonds. 

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What is the Yes Bank AT1 bond issue all about?

Yes Bank saw a significant spike in its non-performing assets and shrinking deposits between September 2019 and March 2020. The RBI decided to intervene before the financials went further downhill. It placed restrictions on depositors withdrawing their money from March 5, 2020, and appointed an administrator. SBI was roped in to infuse equity into the bank, while a reconstruction package was devised. This reconstruction scheme required Yes Bank’s creditors to take a haircut. The RBI decided that the bank’s AT1 bond obligations were to be permanently written off.

But this write-off shocked some of the investors in Yes Bank’s AT1 bonds.

They complained that when Yes Bank staff sold them these AT1 bonds, they were not told about their principal or coupon write-off features. Nor were they aware of these bonds being perpetual. They clearly did not read the information memorandum that mentions these risk factors.

SEBI’s investigations found that Yes Bank officials were guilty of mis-selling these bonds to unsuitable investors such as senior citizens, with institutional investors offloading their bonds to retail clients. It passed orders and imposed penalties on Yes Bank top executives. But investors in the bonds also banded together to challenge the write-off decision in the courts. Last week, the Bombay High Court passed an order staying the write-off of Yes Bank’s AT1 bonds on technical grounds. It isn’t clear yet, if Yes Bank will appeal this decision.  

Will Yes Bank’s finances be hurt if the Bombay High Court order is implemented?

Not very materially. The court order essentially requires Yes Bank to restore the Tier 1 bonds valued at over ₹8,300 crore in its books, while taking an equity write-off. This would effectively mean that the bank’s equity capital would take about a 3 per cent hit, which would be made up if the Tier 1 bonds are restored. Should Yes Bank decide to repay the bonds, its Tier 1 capital can take a 3 per cent dent, which it will have to make up through a new equity or Tier 1 bond issue. There is also a possibility that Tier 1 bond holders will be allowed to convert their holdings into Yes Bank shares, in which case there will be no impact.

Are these AT1 bonds safe for investors? Which category of investors should invest in them?

As the RBI and banks enjoy complete discretion to skip interest payouts, defer the call option or write-off the principal on AT1 bonds, they are wholly unsuitable for retail investors.

After the Yes Bank fiasco, SEBI had ruled that AT1 bonds should be sold only in minimum ticket sizes of ₹1 crore and above, to institutional investors. But older tranches of AT1 bonds continue to trade at lower lot sizes of ₹10 lakh in the market. They are offered to individual investors by brokers, as ‘high yield’ FD substitutes. Only investors willing to take the risk of capital losses with a sufficiently high net worth to invest such a large sum, must even consider them.