The government and the RBI seem to have worked overtime just before the weekend to put together a bailout package for YES Bank. With the SBI taking up an equity stake in the bank and a lookout on for other white knights, depositors in the troubled bank can probably look forward to an amicable resolution.

But one segment of investors which has been left high and dry is the holders of the bank’s AT1 bonds. Social media feeds are now full of folks who have invested substantial sums in these bonds, only to receive a rude shock from the bailout package, which proposes to completely write off the dues on these bonds

What is it?

AT-1, short for Additional Tier-1 bonds, are a type of unsecured, perpetual bonds that banks issue to shore up their core capital base to meet the Basel-III norms. After a string of banks turned turtle in the global financial crisis, central banks got together and decided to formulate new rules (called the Basel-III norms) that would make them maintain stronger balance sheets.

In India, one of the key new rules brought in was that banks must maintain capital at a minimum ratio of 11.5 per cent of their risk-weighted loans. Of this, 9.5 per cent needs to be in Tier-1 capital and 2 per cent 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.

Why is it important?

AT-1 bonds have several unusual features lurking in their fine print, which make them very different from plain-vanilla bonds. One, these bonds are perpetual and carry no maturity date. Instead, they carry call options that 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. A furious debate is now on, on whether AT1 bond holders should be asked to take this haircut when even the YES Bank shareholders are better off

Why should I care?

AT-1 bonds are complex hybrid instruments, ideally meant for institutions and smart investors who can decipher their terms and assess if their higher rates compensate for their higher risks. But in India, these bonds seem to have been sold to a fair number of retail investors as fixed deposit or NCD substitutes.

AT-1 bonds carry a face value of ₹10 lakh per bond. There are two routes through which retail folk have acquired these bonds — initial private placement offers of AT-1 bonds by banks seeking to raise money; or secondary market buys of already-traded AT-1 bonds based on recommendations from brokers.

So, if you are approached by a relationship manager or broker to buy a ‘bank bond’ offering a rather mouth-watering yield, check if you’re being sold AT1 bonds.

The bottomline

Whenever a bond offers extra yield, look for the wolf in sheep’s clothing.

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