Investors who have bought perpetual bonds of Banks that could recall the bonds due to their NPA issues can see either a positive or a negative impact, depending on the price at which they have bought the bonds. Investors who have bought the bonds at face value or discount to face value due to spike in yields of the bonds will see a positive impact as the bonds will be recalled at face value. Investors who have bought the bonds at a premium to face value would lose money as they have to write off the premium immediately.
The recall of bonds also highlights the risk of perpetual AT1 bonds, which was pushed aside by investors as they lapped up all primary issuances of the bonds given higher levels of yields and spreads and comfort of government ownership. Liquidity vanished for the bonds on their NPA issues, briefly came back on bank recapitalisation plan of the government and again vanished after the PNB scam. Read our note on Perpetual Bonds.
Pricing of these bonds were vague as the banks had an option to call back the bonds any time after five years from issue data. Call option pricing for bonds in India is extremely difficult given the inadequacies of yield curves.
Public sector banks that are under RBI prompt corrective action list are likely to recall their perpetual bonds (AT-1, additional tier 1), issued under Basel-III capital norms, AT-1 bonds, also known as perpetual bonds, are sold by banks with an option to call at the end of 5th or 10th year. Recall takes place on any regulatory event.
As per a report by ICRA, AT-1 bonds worth Rs 376 billion can be re-called by banks. ICRA in its report said, two public sector banks Bank of Maharashtra and Oriental Bank of Commerce have already issued notices to their AT-1 bondholders, about an exercise of an early call option on their AT-1 bonds. AT-1 bonds can be recalled before the date of a call option if there is a regulatory event, and these are replaced with similar or better quality capital. RBI has confirmed that capital infused under the recent recapitalisation programme can be utilised to replace the existing AT-1 bonds and subsequent instructions from the government to recall their AT-1 bonds, have triggered early calls by banks.
As per ICRA report, PSB banks had AT-1 bonds outstanding worth Rs 603 billion, Out of the banks that are currently under the PCA or are likely to come under PCA, about 60% of AT-I bonds totalling Rs 376 billion can be recalled earlier. 11 out of 21 PSBs have been placed under the PCA framework (banks under PCA framework cant expand its loan books).
Why Banks can recall AT-1 Bonds
In past years public sector banks had raised AT-1 bonds worth Rs 603 billion to improve there Tier 1 capital ratio (Tier I is regulatory capital. It consists mainly of share capital and disclosed reserves. Tier I components are deemed to be of the highest quality because they are fully available to cover losses Hence it is also termed as core capital. Basel-III Tier-I non-equity capital comprises preference shares and perpetual bonds.Tier I capital has two components, Common Equity Tier I and Additional Tier I.It is a going-concern capital that means banks can absorb losses without triggering bankruptcy.) With huge losses, public sector banks ability to service coupon payment for AT-1 bonds is difficult, as the bond can be serviced through profits for the year or accumulated profits. Therefore with early recall risk of skipping coupon payment will be reduced.