The AT-1 Bond Blowout Is About To Hit Home

This blowout, which began with the Reserve Bank of India’s decision to write-down AT-1 bonds as part of the resolution plan for Yes Bank Ltd. and ended with the Securities and Exchange Board of India altering valuation rules for these securities, is only now hitting home.

Over this fiscal year and the next, more than Rs 55,000 crore worth of AT-1 bonds are coming due from both private and public lenders. With limited appetite for these securities in the local market, lenders are exploring a number of options ranging from raising funds overseas to tapping the local market in smaller tranches.

AT-1 bonds are perpetual bonds which add to the capital base of banks. These securities typically have a five-year call option to give investors an exit route.

According to data from ICRA, Rs 31,290 crore in AT-1 securities will see the first call option being exercised in FY22. Close to Rs 7,925 crore of these bonds are issued by private banks, while Rs 23,365 crore are from government lenders. In FY23, Rs 25,355 crore in these bonds will come up against the first call option.

While technically banks can choose not to exercise the first call option, most investors in India expect them to, said Anil Gupta, head of financial sector ratings at ICRA Ltd. “As such, banks need to be prepared to replenish that capital. Also since the RBI’s large exposure framework links group exposure to tier-1 capital, most banks will want to maintain this at a certain threshold even if they are more broadly comfortable on capital,” Gupta said.

The large exposure framework specifies how much a bank can lend to a single borrower or a group and this limit is linked to tier-1 capital.

In preparing to replenish this capital, some banks have secured board approvals to raise fresh funds.

HDFC Bank Ltd. has hired investment banks to consider the possibility of raising between $500 million and $1 billion from the issue of such securities in the offshore market. While the plan remains on the table, the bank has so far not managed to get the kind of pricing it hopes for, said a person familiar with the matter. In the interim, HDFC Bank may look to sell a smaller number of such securities in the local market, this person added. Eventually though, the lender will have to go offshore given the amount of capital it wants to raise.

An email sent to HDFC Bank on Wednesday went unanswered.

In June, State Bank of India also secured board approval to raise AT-1 bonds overseas or locally.

The country's largest lender has been seeking feedback on whether it should consider a fixed or floating rate bond in the local market, said a market participant who spoke on the condition of anonymity. Floating rate bonds have found greater interest in recent months, this person said.

An email sent to SBI on Wednesday was not answered.

Other large lenders, including ICICI Bank Ltd. and Axis Bank Ltd., too, may have to weigh their options as each sees their perpetual debt come up for call.

According to Ajay Manglunia, head of institutional fixed income at JM Financial, while the cost of raising perpetual bonds in the offshore market would be 4-5%, if fully hedged, the cost would be higher than in the local markets.

While banks may have the option to not hedge these funds and hold them overseas, this may not be a preferred option, he explained.

Local markets, meanwhile, are a bit like Schrödinger's cat—there has been limited activity to test whether the markets are dead or alive.

In March, Bank of India raised about Rs 600 crore via AT-1 bonds at a coupon rate of 9.30%.

If large issues come to market now, will there be material interest from mutual funds?

Lakshmi Iyer, chief investment officer for debt at Kotak Mahindra Asset Management, is not sure there will be. The size of borrowings will be an issue, Iyer said. Mutual funds will have limited appetite as there have been no meaningful flows into schemes that may want to subscribe to this paper, she said.

Manglunia said appetite has dried up across most investor segments. Mutual funds are likely to stay on the sidelines because of the new valuation rules issued by SEBI, he said.

As per these rules, the deemed residual maturity of these bonds will be 10 years until March 31, 2022. It will be increased to 20 years from April 1, 2022 to September 2022, and 30 years for the next six months. From April 2023, the residual maturity will become 100 years from the date of issuance of the bond.

With limited interest from funds, high net worth individual investors also tend to get skittish about investing in these securities as liquidity dries up further, he said. Insurance companies, meanwhile, have stayed on the sidelines as rules which govern their investments say that they can only invest in perpetual bonds of dividend-paying banks. However, last year, the RBI had stopped banks from paying dividends due to the Covid-19 crisis.

Broadly, appetite is down across segments, Manglunia said.

Will that mean that banks may have to bite the bullet and raise offshore funds even if at a higher cost? ICRA's Gupta thinks so.

“Given the disruption in the local AT-1 market, there is little appetite from mutual funds. As such, banks may have to consider going overseas to raise this capital. Large banks should be well placed to draw investor appetite in the overseas markets given that liquidity conditions are comfortable and abundant," Gupta said. "Banks would, however, need to weigh all-in-cost pricing in rupee terms of funds raised overseas.”