Under Basel III norms, the Additional Tier 1 bonds are required to absorb capital losses while the bank remains a going concern.
Debt investors are finding bank bonds issued under the old Basel II norms more attractive, after the recent near-failure of Yes Bank AT1 bonds highlighted the equity-like risks in bonds compliant with modern Basel III rules, widely considered as gold standard for banks. Several investors are looking for opportunities in bank bonds issued under Basel II framework, rather than Basel III, as the norms seem to be less stringent. Further, market experts say that investors are finding comfort in less safer Basel II bonds for now, while trying to fully comprehend the nuances of new Basel III regulations.
“It’s a layer of buffer economy, because of which banks are shifting towards the Basel II norms and meanwhile they are trying to understand the Basel III framework,” Ravi Singh, VP – Research Head, Karvy Stock Broking, told Financial Express Online. Though Basel III bonds are safer than Basel II, the difference is that banks may fail to meet the stringent liquidity coverage ratio and market discipline required under Basel III, which the investors see as a key risk, Ravi Singh said.
Equity risk, bond income
Basel III bonds, as highlighted by the Yes Bank issue, have write-off risk in certain conditions, which makes it riskier than even stocks. On the other hand, the low income on these bonds makes risk-reward unfavourable, says a fund manager. “As per the risk reward metric, if you have more risk than equities, then your reward should be higher than equities. In that case, you cannot be satisfied with 9-12 per cent kind of returns on bonds, because generally equity capital cost or expectation is 15-20 per cent” Alok Singh, Chief Investment Officer, BOI AXA Investment Managers Ltd, told Financial Express Online. Fixed income investors, who don’t want to take equity-kind-of-risk, is why people are trying to shift to old Basel II bonds, Alok Singh said.
Under Basel III norms, the Additional Tier 1 bonds are required to absorb capital losses while the bank remains a going concern. Several investors got a rude shock recently about this fact when the Reserve Bank of India proposed to extinguish Rs 10,000 crore of outstanding AT1 bonds of Yes Bank, as part of a mega recapitalisation plan to save the floundering private lender. In case of Basel II there is no clause for writing off or converting AT1 and Tier II capital to common equity, and hence, small finance banks prefer raising money under this framework.
This difference is what adds to the capital risk in fixed-income investors’ portfolios, which they are looking to shed now. “Suppose I have invested in an income fund, which is not supposed to take an excessive amount of credit risk. Now, if I am holding a Basel III bond then that means I am taking excessive credit risk,” Alok Singh added.