How should you buy perpetual bonds of Indians banks

Learn to identify and avoid bonds from potentially weak banks even if the coupon rate is quite high; guard against mis-selling attempts which are quite prevalent

Kumar Shankar Roy Mar 9, 2020

Investing in bondsGeorge Bernard Shaw once remarked that a perpetual holiday is a good working definition of hell. Yet when it comes to investments, something that pays a stream of cash payments continuing forever is highly valued. Possibly this is the reason Yes Bank was able to raise Rs 10,800 crore by allotting additional tier 1 perpetual bonds. Right from mutual funds, insurance companies, housing finance companies to retail investors, everyone bought into this seductive idea of perpetuity. This is just one bank. Many more banks, weak and strong, have sold such perpetual bonds to different classes of investors. New issues will come up once the dust settles. Promising annual coupon rates of 9% to 10.5%, these unsecured subordinated perpetual additional tier 1 bonds are not without real risks. Read on to know more.

Guard against AT1 bonds mis-selling

The fate of Yes Bank additional tier 1 bonds have caused heartburn. In the draft reconstruction plan for Yes Bank announced by RBI, the instruments qualifying as Additional Tier 1 capital issued by Yes Bank Ltd under Basel III framework shall stand written down permanently in full. This means these bonds will not pay any interest going forward. In effect, they will become worthless for those holding such bonds.

Mis-selling seems to have been rampant in the case of AT1 bonds. Many such bond holders refuse to understand how AT1 bonds can be written down in full, when the issuing company’s shares still exist and the bank is not bankrupt. They argue that AT1 bonds are superior to the claims of investors in equity shares and perpetual non-cumulative preference shares. This is true. But the loss absorbency feature of AT1 bonds makes them riskier than even pure equity!

If the relevant authorities decide to reconstitute an issuing bank or amalgamate the bank with any other bank under Section 45 of the Banking Regulation Act, 1949, the bond issuing bank will be deemed as non-viable or approaching non-viability and both the pre-specified trigger and the trigger at the point of non-viability for write-down of the bonds will be activated. Accordingly, the bonds will be written-down permanently before such amalgamation / reconstitution. The chances of such an event were remote, but not impossible. That’s what has happened today in the case of Yes Bank.

Horror stories of mis-selling have come to the fore via the social media. Retired people, widows and gullible retail investors were sold these AT1 bonds. In many cases, these gullible investors bought only 1 bond since these bonds have a face value of Rs 10 lakh each. They were sold these instruments with terms like ‘high quality’ and ‘long term’. But, risks were not even explained. Bank relationship managers and wealth advisors coaxed them to buy these bonds. The perpetual interest benefit helped seal the deal.

While buying, some investors had even asked about the liquidity of AT1 bonds. These queries were met with the response that the bonds are proposed to be listed on the wholesale debt market (WDM) segment of NSE and/or BSE. No one, however, told them that these bonds are rarely traded, making them illiquid.

Tip: A lesson from this is to be on guard against mis-selling attempts. The person selling such bonds wants to complete the transaction and will lie if required. They can earn a fat commission. Hence, the onus is on you as an investor to read all the documents and understand the risks. We would request senior citizens and those with small amount of capital to totally avoid AT1 bonds. These bonds are not an alternative to bank FDs!

Do not expose your modest portfolio to such risks for the sake of higher than bank FD return. Adopt a conservative stance and invest in only guaranteed safe products, even if you have to sacrifice returns a bit. Once you have crossed your earning phase, even a small mistake means a huge hit.

Avoid buying AT1 bonds of weak banks

In the financial market, all types of products will exist. Banks of all types will raise money. Or, atleast they will try to.

Yes Bank fell in the weak bank segment. There are many more banks in the private sector that are weak. Some of them have done IPOs in the last 4-5 years. Some of them have tried to merge with other companies, but things didn’t work out. Weaker private sector banks are in a much dangerous situation compared to state-owned banks, which are always rescued by their promoter i.e. the Government.

A weak bank can be defined in various ways. Typically, a weak bank is one whose liquidity or solvency is impaired or will soon be impaired unless there is a major improvement in its financial resources, risk profile, business model, risk management systems and controls, and/or quality of governance and management in a timely manner.

The most easy ways to identify a weak bank are poor governance or management; inadequate financial resources (capital and
liquidity); a non-viable business model or strategy; weak asset quality; and poor systems and controls.

Banks do not become weak overnight. The problems that seem to emerge rapidly are often a sign of financial or governance/ managerial weaknesses that have been allowed to persist for some time. Banking regulators are supposed to identify weak banks and nurse them back to health. But, RBI is not particularly great in terms of doing that. It may identify problems in a bank much later. So, the risk of you being sold AT1 bonds of a weak bank always lurk in the shadow.

One of the ways to identify a potentially weak bank is to read news especially related to violation of norms. Banks that are slapped fines/penalties should also ring bells. There is something wrong in such banks and as a precautionary move, avoid dealing in instruments of such banks.

Even top investment managers, however, failed to see problems at Yes Bank. So, don’t be too hard on yourself if you as an average investor are bad at identifying weak banks. Three fund-houses viz. Nippon India MF, Baroda MF and UTI MF have created segregated portfolio of Yes Bank securities. Indiabulls Housing Finance also made investments in AT1 bonds of Yes Bank.

Tip: One way to ring-fence your portfolio is to invest in AT1 bonds of different banks. Avoid any form of concentration. Try to bring diversity through purchase of AT1 bonds from different types of banks. Of course, this depends on actual issuances and your investment capacity.

If you have just Rs 10 lakh to invest, stay away from AT1 bonds. Do not think of AT1 bonds as debt/fixed income asset class. Use such bonds as per your asset allocation design.


Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. Kumar is a financial journalist, with a functional experience of 15 years. He tracks mutual funds, insurance, pension, PMS, fixed income/debt and alternative investments markets closely. He has worked for The Times of India, The Hindu Business Line, Deccan Chronicle Group, DNA, and Value Research, among others, across different cities in India. He is deeply interested in marrying data insights with actionable opinion. He can be contacted at kumarsroy@rupeeiq.com.

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