19 Oct 2016 15:48 IST

Why are bank bonds under focus?

Beleaguered public sector banks have been in news for possibly defaulting on their bond payments

Much has been said about public sector banks’ bad loans and the sharp fall in earnings in the last two years. So much so, that no number seems too outlandish when it comes to these banks reporting losses in their quarterly results — even if it is a few thousand crores. But of late, these beleaguered banks have been in news for another reason — i.e. being on the verge of a possible default on their bond payments.

In the June quarter, Indian Overseas Bank, that reported a lower than mandated capital ratio of 9.47 per cent (against 9.625 per cent), managed to avert a default on its bonds only because the Centre infused capital into the bank.

But the risk that these bank bonds face due to the deterioration of asset quality remains a gnawing concern; and in many cases, cannot be wished away by the Centre’s largesse. Only recently, CRISIL had cautioned that four state-owned banks may find it difficult to service their interest payments on their bonds.

What are these bank bonds and why the hullabaloo over them?

Need for capital

It is a known fact that banks rely heavily on large amounts of deposits for their lending activity. But they need large buffers of capital to withstand shocks from loss on account of defaults by its borrowers.

Banks — both public and private — have been stepping up their capital raising efforts to meet the Basel III requirements and also to fund their growth. But with one notable difference. While private banks have been able to raise funds from the capital market, for public sector banks that are saddled with huge losses, tapping the market has been a tall task. Hence state-owned banks have resorted to raising funds by issuing Basel-III compliant bonds — Additional Tier 1 (AT1) and Tier II.

The unique feature of these bonds is that banks can exercise their right of discretionary payment of coupons (interest) at an early stage of trouble at the bank. AT 1 Bonds are riskier. The coupon on AT1 bonds can only be serviced through current year’s profit or from revenue reserves. In case of stress, banks can write down the principal value of the bond or convert them into equity shares.

Tier II bonds come with a lock-in clause, wherein banks are not liable to pay interest or principal if the bank’s capital ratio falls below the regulatory requirement.

It is because of these unique features that these bonds have been in focus recently. Given public sector banks’ mounting losses and weakening capital ratio, these bonds are more prone to the risk of possible defaults now, than in the past.

Since March, most PSU banks’ capital ratios have fallen and a few are just about meeting the requirement as of June quarter — United Bank, UCO Bank, Central Bank of India and Indian Overseas Bank, to name a few.

But how does a bank’s ability to service its payments on its bonds matter to you and me?

Take note

As a depositor, the implications are more indirect and can serve as early warnings signals of the deteriorating state of affairs at your bank. Capital-crunched banks with weak core performance are more likely to run the risk of defaulting on these bonds. While in India, instances of commercial banks going kaput are very rare, it may be wise to run a check on your bank to see if it is in trouble.

As an investor — the RBI allows retail participation — the ability of a bank to service its interest payments, no doubt directly impacts you. That being the case, why invest in these bonds at all?

Deposit rates have been falling sharply in recent months. For retail investors in the fixed income category, the tax-free bond ‘tap’ has also been running dry. The high interest rates (upwards of 8 per cent in recent issues) that bank bonds offer are, thus, a big draw for investors. For risk takers who understand the complexity in these instruments, it may pay to invest selectively in these bonds.

Watching out for early warnings signals, such as a combination of weak capital and rising bad loans, can help mitigate risk. Ratings assigned to these bonds can also help assess the risk. Rating agencies take into account a bank’s profitability, track record of maintaining sufficient capital cushion, asset quality trends and adequacy of revenue reserves among other parameters, to rate bank bonds.

CRISIL has currently assigned an ‘AA’ rating to Central Bank of India’s Tier II bonds and a AAA rating to that of Union Bank of India’s bonds. Keeping a tab on such ratings and their subsequent revision can help ward off some risks.

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