Perpetual or AT 1 bonds are back, this time in PSU banks. Should you invest?

Almost two and a half years ago, when Yes Bank canceled its perpetual bonds in March 2020, several investors were left behind. The risks of perpetual bonds were then highlighted, but it seems that banks have not stopped issuing these bonds.

Union Bank of India said last week that it plans to raise 1,320 crore rupees next week by issuing bonds on a private placement basis. “Additional unsecured, subordinated, taxable, non-convertible, perpetual, fully paid Tier I Basel III compliant bonds, in the form of debentures, will carry a coupon of 8.69% per annum,” the public lender said in a statement. a regulatory statement. filing, according to a PTI report.

Recently, an individual pointed out in a social media post that his banking relationship manager asked him if he wanted to invest in perpetual bonds. “My bank RM offers me to invest in privately placed perpetual bonds. Interest rates seem to be very good, but I don’t know much about it. I would appreciate if someone understands this product better,” he posted on social media, seeking advice.

Perpetual bonds or additional Level I bonds are attractive because they generally offer higher interest rates than bank term deposits. However, past experience shows that it doesn’t make sense for investors to put money into it without understanding the risks involved. Read on to find out what these bonds are and what to look out for when investing in them.

What are perpetual bonds?

As the name suggests, perpetual bonds are those that exist in perpetuity or until the lifetime of the respective bond issuer. Ankit Gupta, founder of BondsIndia.com, a bond investment platform, says these bonds have no maturity date and interest is paid until the life of the bonds, subject to certain conditions .

“Perpetual bonds are usually issued with a call option, which basically means that these bonds can be called by the issuer at any time after a set period. Call option here refers to an option where the The bond issuer can recall the bond and repay the principal amount to the bondholder/investor,” he adds.

Typically, the call option is exercised at the end of a minimum of five years, says Ajay Manglunia, Managing Director and Head, Investment Grade Group, JM Financial.

However, banks are not required to exercise the call option. In case of financial difficulties, banks can decide not to do so, which happened in the case of Yes Bank. In such cases, investors’ capital can be completely wiped out.

Also, the issuer/lender has the right to call them back and issue them at cheaper rates when interest rates drop, says Kartik Parekh, Sebi-registered investment adviser and co-founder of Gochanakya, a fintech platform. .

Growing popularity

“Over the years, the government has shown immense support for the development of the market to ensure that even in the most difficult times, AT1s (additional tier I) issued by PSU banks do well,” Manglunia says.

Recently, the popularity of these bonds has increased. AT1 bonds issued by Punjab National Bank and Canara Bank have recently been “overtaken by banks, institutions, corporate treasuries and HNIs”, he says. These shows were worth Rs 2,000 crore each. In the past, “the market had issuers from private banks and PSU banks operating the market. However, in recent years, the majority of issuance has come solely from PSU banks,” says Manglunia.

Chart showing the various perpetual AT1 bond issues by banks in India – Courtesy of JM Financial

Risks to watch out for

Just because institutional investors seem to be interested in these bonds does not mean that they are ideal for retail investors, who must decide if they are ready to face the risks associated with these bonds.

Unsecured nature of the bonds: Manglunia points out that “all PSU banks have so far either paid their obligations on time, such as servicing coupons, and have always exercised the call option on the option date. This gave investors a lot of comfort and they participated because it gives better returns. »

However, he adds that investors should understand that these bonds are capital instruments “and not exactly borrowings and in case of hierarchy of insolvency proceedings, they are behind deposits, borrowings and Tier II bonds”. This essentially means that investors in these bonds will be compensated after others have been taken care of in the chain of command, in case something goes wrong.

“They are inherently unsecured and in the event of default are likely to result in zero recovery if fully amortized. This is exactly what happened in the case of Yes Bank’s AT1 perpetual bonds he says.

Different concept: Perpetual or AT1 bonds fall into a specialized category of bonds, in which “coupon/principal payments are discretionary.” It is not a safe/relevant instrument for retail. This is only for specialist investors who understand the nuances of these bonds and can take an informed call,” Manglunia says.

Only those capable of taking higher risks and putting their capital at risk should consider these bonds. “These bonds are issued mainly by banks under BASEL III standards and only individuals who can take a higher risk on capital should opt for these bonds. Indeed, in some special cases, as happened with Yes Bank, they can be completely written out,” says Parekh.

Non-Compulsory Payment: Gupta explains that these bonds are part of the Tier 1 capital of the bank or institution, which helps keep the debt ratio under control. “Liability to pay interest or principal is not binding in the event of losses incurred or insufficient profits made by the business,” he says.

“Furthermore, these bonds are ‘going concern’ instruments, which essentially means that the instrument can default even if the bank continues to operate as a ‘going concern’, which is not not the case with normal bonds or NCDs (non-convertible debentures), where if the company defaults, it’s ‘gone business’,” adds Manglunia.

Ticket size and other details: Generally, the minimum note size or face value of these bonds is Rs 1 crore. “The regulator has fortunately increased the minimum ticket size so that the extent of retailer involvement in these bonds can be limited. But, as these bonds are listed, rated and traded on the markets and are held in demat and not in physical certificate, certainly any HNI or retail can buy it.

“If an investor has Rs 1 crore or more and wants to buy these high-risk, high-yield bonds, they can do that, but they have to understand that there is a high risk element involved,” adds Parekh.

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