Basel Compliant Bonds

  • September 23, 2022
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Basel Compliant Bonds

Subject: Economy

Context:

Indian banks may continue their fundraising by issuing Basel III-compliant and infrastructure bonds as they rush to meet rising credit demand and lock in funds at cheaper rates.

Details:

State-run banks have already raised ₹281 billion through a combination of Basel III-compliant additional Tier I perpetual bonds, Tier II bonds and infrastructure bonds in the last three months.

Concept:

AT1 bonds

  • AT-1 bonds are a type of unsecured, perpetual bonds that banks issue to shore up their core capital base to meet the Basel-III norms.
    • These bonds were introduced by the Basel accord after the global financial crisis to protect depositors.
  • There are two routes through which these bonds can be acquired:
    • Initial private placement offers of AT-1 bonds by banks seeking to raise money.
    • Secondary market buys of already-traded AT-1 bonds.
  • These bonds are also listed and traded on the exchanges. So, if an AT-1 bondholder needs money, he can sell it in the secondary market.
  • Investors cannot return these bonds to the issuing bank and get the money. i.e there is no put option available to its holders.
  • The issuing banks have the option to recall AT-1 bonds issued by them (termed call options that allow banks to redeem them after 5 or 10 years).
  • Banks issuing AT-1 bonds can skip interest payouts for a particular year or even reduce the bonds’ face value.
  • These bonds are perpetual in nature — they do not carry any maturity date.
  • They offer higher returns to investors but compared with other vanilla debt products, these instruments carry a higher risk as well.
  • These bonds are subordinate to all other debt and senior only to equity.
  • Basel-III-compliant AT 1 bonds come with a built-in ‘loss absorbency’ clause which means that in case of stress, banks can write off such investments or convert them into equity.
    • The principal loss absorption (through write-down or conversion into equity shares) can be triggered by pre-specified trigger of CET1 falling below 5.5 per cent before March 2019 and 6.125 per cent thereafter.
  • At the instance of the RBI, bonds can also be written down upon a point of non-viability (PONV) event happening.
    • The PONV trigger event is the earlier of a) decision that a conversion or write-off, without which the firm would become non-viable, is necessary, b) decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable.
    • The norms also state that if the authorities decide to reconstitute a bank or amalgamate a bank with any other bank under Section 45 of BR Act, 1949, then such a bank will be deemed as non-viable or approaching non-viability.
  • If the bank reaches the point of non-viability, AT1 bonds are the first part of debt that will be written down. 

Tier 2 bonds 

  • These are components of tier 2 capital, primarily for banks.
  • These are debt instruments like loans, more than they are equity features like stocks.
  • As with all bonds and other debt instruments, they do not give ownership or voting rights, but they do offer interest earnings to bondholders or owners.
  • “Guaranteed” is not an appropriate word to be used for tier 2 bonds but it “specifies” earnings as interest rates.
  • Tier 2 bonds are typically subordinated debt, behind tier one debt such as commercial loans.
  • In the case of Basel III Tier 2 bonds, the principal can be fully written down at the PONV.
    • While both Tier-1 and -2 instruments have significant loss-absorption features, the former are meant to absorb losses on a going-concern basis — the loss-absorption trigger kicks in fairly early. Hence, the high loss-absorption features of Tier-1 bonds can bail out depositors as well as investors in Tier 2 bonds, well ahead of a crisis or stress.
    • The relatively lower risk in Tier 2 bonds compared to AT 1 bonds is reflective in the ratings of these bonds.
      • Ratings for tier 1 instruments are notched down by both domestic and global rating compared to ratings assigned to the Tier 2 bonds.

Infrastructure bonds

  • These are borrowings to be invested in government funded infrastructure projects within a country.
  • They are issued by governments or government authorised Infrastructure companies or Non- Banking Financial Companies.
  • They offer a decent rate of interest and tax benefits.
  • The maturity of these bonds is often between 10 to 15 years with an option to buy-back after a lock-in of 5 years.
  • These bonds are listed either on or both National Stock Exchange or Bombay Stock Exchange that provides you with an option to exit after the lock-in period.
    • A Lock-in period is when you cannot sell a particular instrument.
  • These bonds provide deductions up to Rs 20,000 from the taxable income under section 80CCF of the Income Tax Act; however the interest on the bonds is taxable in the hands of investors.
    • So, the tax-saving long-term infrastructure bonds were basically not the tax-free bonds.
Basel Compliant Bonds economy