Why in the News?
- The Insurance Regulatory and Development Authority of India (IRDAI) has permitted insurers and reinsurers to invest in Additional Tier-1 (AT1) Bonds and certain Tier-2 capital instruments issued by RBI-regulated All India Financial Institutions (AIFIs).
- This follows the RBI’s decision (effective April 1, 2024) allowing AIFIs to raise capital through AT1 Bonds and Tier-2 instruments under the Basel III Capital Framework.
What is a Bond?
- A bond is a fixed-income financial instrument through which an investor lends money to a government or corporate entity.
- In return, the issuer pays regular interest (coupon payments) to the investor.
- Bonds are issued for a specified time period, known as the term to maturity, after which the principal is repaid.
- Funds raised through bonds are used for purposes such as business expansion, refinancing existing debt, infrastructure development, or welfare activities.
What are Additional Tier-1 (AT1) Bonds?
- AT-1 bonds are perpetual bonds, meaning they do not have a maturity date.
- Investors do not have a contractual right to receive back the principal.
- These bonds form part of a bank or financial institution’s Tier-1 Capital, along with Common Equity Tier-1 (CET-1).
- Due to their perpetual nature and loss-absorption features, AT-1 bonds are often treated closer to equity than conventional debt.
Key Characteristics of AT1 Bond
- Perpetual in nature: No fixed redemption date.
- Higher interest (coupon) rate: Offered to compensate for higher risk.
- Discretionary coupon payments: Issuer may skip interest payments without it being treated as a default.
- Call option available: Issuer may buy back the bonds after a specified period (usually 5 years), subject to RBI approval.
- No put option: Investors cannot demand early redemption from the issuer.
- Listed instruments: Investors can exit only through secondary market sale.
- Subordinated debt: In liquidation, AT-1 bonds rank below all other debt instruments, but above equity.
How are AT-1 Bonds Issued?
- AT-1 bonds are issued by banks and eligible financial institutions in accordance with RBI guidelines.
- They are issued primarily to meet Capital Adequacy Requirements (CAR).
- Capital Adequacy Ratio (CAR):
- Measures a bank’s capital in relation to its risk-weighted assets.
- Ensures banks can absorb losses and protect depositors.
- The CAR framework in India is aligned with the Basel III Accord (2009), introduced after the 2008 global financial crisis.
Basel III Norms and AT-1 Bonds
- Basel III strengthened bank capital norms to improve financial stability.
- Tier-1 Capital
- Common Equity Tier-1 (CET-1): Equity and retained earnings.
- Additional Tier-1 (AT1): Perpetual, loss-absorbing instruments.
- Tier-1 Capital: CET-1 + AT-1
- Tier-2 Capital
- Subordinated debt and certain non-cumulative preference shares.
- Funds raised through AT-1 bonds act as a shock absorber during financial stress.
AT-1 Bonds as Contingent Convertible Bonds (CoCos)
- AT-1 bonds are a form of Contingent Convertible Bonds (CoCos).
- If a bank’s capital falls below a specified threshold:
- AT-1 bonds can be converted into equity, or
- Written down (partially or fully).
- This mechanism helps the bank reduce debt and restore capital strength.
Risks Associated with AT-1 Bonds
- Principal loss risk: The principal can be written down permanently.
- Equity conversion risk: Bonds may be converted into equity at stressed valuations.
- Coupon cancellation risk: Interest payments can be skipped indefinitely.
- Regulatory intervention risk: RBI can trigger write-down or conversion without investor consent if the bank is under stress.
- Perpetual risk: No certainty of redemption due to absence of maturity.
- Subordination risk: AT-1 bondholders are paid after all other creditors in liquidation.
- High suitability risk: These instruments are unsuitable for conservative investors.
About All India Financial Institutions (AIFIs)
- AIFIs are RBI-regulated development financial institutions that provide long-term finance to priority sectors.
- Examples include NABARD, SIDBI, EXIM Bank, NHB and NaBFID.
- They play a crucial role in infrastructure financing, MSME support, and export promotion.
Regulatory Change for Insurers
- Earlier: Insurers were allowed to invest only in AT1 Bonds and Tier-2 instruments issued by banks.
- Now: IRDAI has expanded the investment universe to include AT1 and Tier-2 instruments issued by AIFIs.
- Objective:
- Portfolio diversification for insurers.
- Better risk-adjusted returns.
- Improved asset–liability management (ALM) for long-term liabilities.
Infrastructure SPVs – Proposed IRDAI Norms
- IRDAI is considering allowing insurers to invest in Special Purpose Vehicles (SPVs) in the infrastructure sector.
- Conditions include:
- The project must have commenced commercial operations.
- Cash flows should be stabilised.
- No requirement of parent company guarantee, net worth, or credit rating.
- Proposed investment limit: Insurers may invest up to 20% of the debt issued by eligible public-limited infrastructure SPVs.
Q. With reference to Additional Tier-1 (AT1) Bonds in India, consider the following statements:
1. AT1 bonds are perpetual instruments and form part of a bank’s Tier-1 Capital under the Basel III framework.
2. Interest payments on AT1 bonds are mandatory, and non-payment is treated as a default by the issuer.
3. AT1 bonds can be written down or converted into equity if the issuing institution’s capital falls below prescribed regulatory thresholds.
Which of the statements given above is/are correct?
(a) 1 and 2 only
(b) 1 and 3 only
(c) 2 and 3 only
(d) 1, 2 and 3
Answer: (b) 1 and 3 only
Explanation:
Statement 1 is correct: AT1 bonds are perpetual (no maturity) instruments and are included in Tier-1 Capital, along with Common Equity Tier-1 (CET-1), as per Basel III norms.
Statement 2 is incorrect: Coupon payments on AT1 bonds are discretionary. The issuer may skip interest payments without it being treated as a default.
Statement 3 is correct: AT1 bonds are loss-absorbing instruments and may be written down (partially or fully) or converted into equity when capital adequacy falls below regulatory thresholds.
