Stay clear of debt securities of banks amid trembling yields and their need for capital. Period.

The recent news article about largest state-run bank raising Rs.4000 crore through AT1 bonds last week must have brought some sour memories of not so recent past. Yes Bank saga underscored the importance of doing financial diligence particularly when the deal looks too lucrative. With many banks treading near the regulatory requirement of capital adequacy and looking to shore up their capital, there is a possibility of investors being lured to such instruments in the chase for yield. Hence, its imperative to remember the basic tenet – oversized returns come with oversized risk – risk of losing the capital itself.

Till the time AT1 bonds shot to fame following liquidity and solvency problems at Yes Bank, I did not even fully know the various instruments being used by banks for capitalisation requirements. All I knew that retail investors can lend to banks only by way of fixed deposits which are also partially insured – thankfully that limit now stands increased to Rs.500,000 per customer per bank from paltry Rs.100,000 till recently. The whole unfolding of how the bank officials through the help of intermediaries coaxed retail investors into buying these bonds though has taught us some important lessons but I feel there are still enough gullible people who could be fooled again as modus operandi could also change when the need arises in future. The regulators prohibit these bonds being sold to retail investors directly by bank and in case of Yes Bank, it was executed through a clutch of institutional intermediaries as secondary sales. Another variant could arise in terms of exposure to these instruments in PMS, mutual funds or through financial advisors managing money on behalf of individuals.

I kind of think that it may not be the one-off case as a recent article from former RBI Deputy Governor, Viral Acharya caught my attention regarding the shortfall in capitalisation of Indian banks at whopping $75bn or 6 lakh crore compared to nil at the end of 2007.

While the same article talks about that 90% of this shortfall is accounted for by 15 public sector entities who have possibly no incentive to engage in such malpractices as they have sovereign backing, there could be few smaller private banks who may fall for similar tricks. Also for these large public sector banks, a large part of this shortfall could likely get met from hybrid and quasi equity instruments as raising equity for many of these PSBs may not be a viable option – lack of investor interest in financial sector let alone PSBs, government financing under stress itself given it has imminent GST tussle to resolve with state governments, valuation issues et all. Thus, we may see many such issues being floated by banks of all sizes and shapes offering the lure of higher interest rate given the inherent risk (loss absorption features as equity) and ofcourse rating differential.

With respect to the rating differential, the differential from secured bonds vs these equity like bonds could range from 1(as in case of SBI) to 4/5 notches (seen in case of PNB) which in itself could send a bit of alarm bell to investors to probe a bit deeper. As the international rating agencies are less forgiving, the differential in SBI internationally rated AT1 bond is about 5 notches from other bonds. Thus, while it would be a better idea to attract foreign investors to such instruments who are grappling for better yields, this would not cut the ice in most cases given the banks ratings tracjectory.

Cutting to the chase, its important of stay clear of such bonds directly (in case any unscruplous opportunity arises) and indirectly through PMS and MFs to the extent possible as a tad higher return is not worth it. Period!

#AT1Bonds #creditrating #safetyoverreturn

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