AT1 bonds and how do they work?
Additional Tier 1 bonds or Contingent Convertible bonds are tradable securities issued by banks with a regular coupon payment. This bond can also be termed as Enhanced Capital Note (ECN). The introduction of AT1 bonds was done by Basel III. They are an international regulatory accord helping to improve the banking regulatory framework.
AT1 bonds are under the regulatory framework of the Finnish Financial Supervisory Authority. AT1 bonds were introduced as a preventive measure to avoid another financial crisis like the Global Financial Crisis in 2008. In the Insurance Industry, this bond is turning up as an alternate option for maintaining solvency.
There is no fixed repayment date for AT1 bonds. The coupon has a variable or fixed rate. These bonds act as Tier 1 capital which helps banks to achieve the capital requirement rules. The Financial Supervisory Authority can restrict or prohibit the payment of interest on these bonds. When the capital of the issuing bank dips below a determined level, this bond absorbs the losses. The bank can write-off, write-down or convert the bonds into equity to absorb losses.
AT1 bonds are subordinated, direct and unsecured instruments. Interest rates of AT1 bonds are higher than traditional bonds. The bondholders get fixed interest payment. The bondholders cannot receive interest if the bank runs into losses in a financial year. Even if the bank has enough cash, it cannot make payments.
If the Tier 1 capital of the issuing bank falls below 5%, The bonds will automatically be converted into equity. This helps the bank to remove the bond debt from its balance sheet. The capital ratio of the bank also starts to improve.
AT1 bonds and Equity
The returns on equity are much higher than the returns on AT1 bonds. The interest accrued and claims of AT1 Investors have more preference than equity investors. Without reducing equity, AT1 bonds cannot be written down. AT1 holders are given the same treatment as equity holders. Therefore, these bonds are not likely to be repaid. The risk in equity is more than AT1 bonds.
Why are AT1 bonds issued?
The primary reason to issue AT1 bonds is to fulfill the regulatory capital requirements. They also help to limit capital distributions. The demand for AT1 bonds has increased. The Investors mainly include those who are ready to take risks. These investors include Retail Investors, Private banks and Institutional investors. The bonds secure the issuers from capital losses. The returns on this bond are more than other debt instruments of the same issuer. In times of crisis, AT1 bonds act as a source of capital for banks.
AT1 bonds and Equity. How do they work?