AT1 Capital or Contingent Convertible Capital Instruments:
Additional tier-1 (AT1) or contingent convertible capital instruments, known as CoCo bonds or Enhanced Capital Note (ECN) are the types of unsecured, perpetual bonds that are issued to absorb losses when the capital of the issuing financial institution falls below the regulatory standards. The purpose behind issuing the contingent convertible bonds is to maintain the ratio as per Basel III norms and existence of banks during the crisis.
As per Basel III norms, a bank must maintain enough capital to be able to withstand a financial crisis and absorb unexpected losses from loans and investments. Total regulatory capital consists of tier-1 capital, which includes common equity tier-1 (CET1) and AT1, as well as tier-2 capital.
- Tier 1 capital – This is referred to as core capital which includes share capital, retained earnings, share premium reserves and AT1 Capital or CoCo Bonds
- Tier 2 capital – This is a supplementary capital which includes revaluation reserves, undisclosed reserves, hybrid capital instruments, subordinated term debts
AT1 or CoCos are debt instruments that are similar to traditional convertible bonds. They have higher rates than Tier II bonds. While an AAA-rated Tier II bond of a bank may have an interest rate of 8% per annum, its AT1 bond can carry a rate of around 10% per annum. These bonds have no maturity and they continue to pay coupons perpetually. CoCos have high yield thus have high risk i.e. returns are more than secured bonds but there is a risk of capital loss. But this comes with the dual risk the issuing bank can skip a coupon payment and if the total regulatory capital is not maintained then the bank can convert bonds to equity or write down these bonds.
When a bank’s capital adequacy ratio falls below the specified limit by regulators AT1 bonds get converted from bonds to equity and the holder of security doesn’t have an option. The severity of the loss in the hands of investors is less severe as he holds equity. Thus indicating the bank is having financial difficulty and as a result, the stock’s price starts declining and investors face losses which in turn reduces Earnings per share (EPS) of the bank.
Book your CFA Demo Session Click Here
Let us consider an example, ABC Bank has issued AT1 bonds. An Investor holds bonds with a face value of $1000 at a 9% coupon rate. The stock is currently trading at $100. The bank’s regulatory capital falls below the limit the bonds are automatically converted into equity. The stock price declines to $50. He gets 20 shares worth $1000. The investor holds the shares and then he experiences a further decline in price to $30. Thus the total value of his investment reduces from $1000 to $600 resulting in a loss of $400. Thus, the investor should take immediate action when the bonds are converted to equity so that loss is minimal.
In case of stress, banks can also write off these bonds from their balance sheet i.e. writing down the debt to zero. Thus in this case the full principal amount is written down to zero. The intensity of the loss is very severe in this case. Let us consider a recent real-life example, in March YES Bank, had written down AT1 bonds worth Rs 8415 crore to zero so the investors won’t be getting their money back.
Book your FRM Demo Session Click Here
Whenever a bond offers an extra yield, the investor should be cautious rather than just focusing on mind-boggling yield.
To summarize the benefits and drawbacks of AT1 bonds mentioned above are –
|Banks can postpone or skip a coupon payment||Converted CoCos to equity will result in an investor receiving shares when the stock price is declining.|
|Banks can write down the debt to zero||Investors won’t get their money back in case the issuer writes down the entire debt.|
|Investors receive higher yields.||Banks have to pay higher interest rates than compared to other traditional convertible bonds.|
Author: Swati Krishnamurthy
About the Author: Swati is a freelance writer. She is a Financial Quality Compliance specialist having integrated knowledge and experience in Logistics, Audit, and Risk-mitigation for manufacturing and service sectors. Her passion for finance grew as she scored centum in financial management during her master’s degree. She’s a classical dancer who performs to express complex emotions through her dancing and writes to express complex concepts into simple words.