The ABC of AT-1 bond crisis

The draft reconstruction scheme for YES Bank proposed by the Reserve Bank of India (RBI) seems to have really put the wind up the investors in the additional tier 1 (AT-1) capital bonds issued by the bank. These investors are crying foul, claiming that despite the AT-1 bonds being “senior” to common equity shares, they are being written down, whereas the equity shares are not. Fund house managers are expressing surprise at the RBI’S interpretation of the rights of AT-1 bondholders vis a vis equity shareholders. Market gurus are fretting about the impact of such a write-down on investor appetite for such bonds and the banks’ ability to viably raise further capital via this route. A national financial daily has gone so far as to say that if large financial institutions fail to honour their commitments, leaving bondholders in the lurch, the creditworthiness of the country itself might take a knock. Overall, there seems to be more drama than light in this debate, and it’s time to place the facts, and their implications, in perspective.

Firstly, AT-1 bonds, by their very design, have an in-built provision for being “bailed in”— that is, their principal amount can be fully or partially written down upon the occurrence of specified pre-defined events, even while the issuing bank continues to function as a going concern. This is the case in respect of the AT-1 bonds issued by YES Bank.

Secondly, while the issued AT-1 bonds have explicit, ex-ante and enforceable write-down provisions, even while the bank continues to function as a going concern, no such provisions apply to common equity shares. This is one of the key characteristics of a bail-in instrument that distinguishes it from common equity.

Thirdly, AT-1 bonds carry a higher rate of return than other debt instruments as their investors agree to accept the additional risk of losing their investment if certain pre-specified events occur, well before explicit losses, if any, are imposed on other categories of investors.

Now what are these pre-specified events? The RBI Basel III regulations state that the AT-1 bonds will be written down or converted to common equity (the terms of the YES Bank AT-1 bonds stipulate a write-down) under two circumstances. The first is when the common equity capital falls below a specified trigger level. The objective of this write-down is to replenish the common equity of the bank, which increases to the extent of the AT1 debt being written down.

The second circumstance under which a write-down would happen is when the RBI determines that the bank has reached a “Point of Non-viability” (PONV) at which it is either necessary to write down the AT-1 debt or make a public sector injection of capital, or equivalent support, or both, in order to restore the viability of the bank. Pertinently, the RBI regulations make it explicitly clear that the write-off of any common equity capital shall not be required before the writeoff of any non-equity (additional tier 1 and tier 2) regulatory capital instrument.

The RBI regulations also make it clear that “if the relevant authorities decide to reconstitute a bank or amalgamate a bank with any other bank under the Section 45 of the Banking Regulation Act, 1949, such a bank will be deemed non-viable or approaching non-viability and both the pre-specified trigger and the trigger at the point of non-viability for conversion / write-down of AT-1 instruments will be activated. Accordingly, the AT-1 instruments will be fully converted/written-down permanently before amalgamation / reconstitution…”.

In the light of the above factual situation, of which the institutional investors were, or should have been, fully aware while investing in these AT1 bonds, it is indeed tragicomic that these so-called savvy investors are now making a brouhaha about the proposed write-down of their AT-1 bond investment. This seems to be nothing but an unethical attempt by these investors to subvert the regulatory process. They entered into this investment fully aware of its risks and, therefore, extracted a higher rate of return when the going was good. Now that the risk has materialised, they want a bail-out. It is hoped that the courts and the regulator will give short shrift to their unreasonable demands.

One aspect that needs the attention of both the RBI and the Securities and Exchange Board of India is that a number of retail lay investors seem to have been sold these AT-1 bonds, either via primary issue or via the secondary market. It is moot whether this category of investors was adequately apprised of the higher risks underlying these bonds, while being enticed by their higher returns. It could well be argued that retail investors should not be eligible to invest in such instruments.

One hopes that, in this case, all stakeholders will “do the right thing”.