FEMA

Issuance of Perpetual Debt Instruments (PDIs) Overseas

Perpetual Debt Instruments

Perpetual debt instruments are types of fund-raising instruments that have no maturity date. Until the company shuts down, dissolves, or the investor still holds the bond, the issuer continues to pay interest. They instead offer to pay their customers a coupon or interest at a set time every year. Perpetual bonds may be issued by a number of organisations. However, banks typically issue Additional Tier 1 (AT-1) bonds to comply with Base III capital requirements. In the case of bank Additional Tier-1 bonds, banks may choose not to pay interest as well as the principal if they run out of capital or become bankrupt. This characteristic and the everlasting nature of these bonds increase the risk for investors, but they often offer larger yields than other debt securities.

Although such bonds’ principal never actually needs to be repaid, issuers do include a call option. Therefore, the issuers have the option to repurchase the bonds from investors after a set period, such as five or ten years from the date of issuance. In the case of traded perpetual bonds, investors may also choose to withdraw their money through the secondary market. Perpetual debt instrument overseas is created when the fund is raised through foreign issuance. These issuers periodically pay pre-agreed interest to investors in return. 

Additional Tier-1 (AT-1) bonds

To boost their core capital base and adhere to Basel III standards, banks issue AT-1 bonds, a sort of perpetual unsecured bond. After several banks failed during the 2008–2009 global financial crisis, these standards, which called for maintaining more substantial balance sheets, were created.

Tier 1 and Tier 2 capital make up the regulatory capital of the banks under Basel III. Common equity (CET-1) and additional tier 1 capital (AT-1) are two categories of tier 1 capital. Equity capital is categorised as CET-1. Permanent Bonds that meet particular criteria outlined by the RBI are categorised as AT-1.

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Additional Tier-1 bonds are unsecured bonds that don’t have a set maturity date. It is a component of a lender’s core capital, also referred to as tier-1 capital. Contingent Convertible (CoCo) bonds are another name for the money raised through these bonds. 

These bonds are retained as a cushion. A bank is free to convert them into equities or write them off in times of crisis or hardship, as happened recently with the Credit Suisse event and the Yes Bank incident from 2020. To assist the faltering private lender, the Reserve Bank of India (RBI) wiped off the AT-1 bonds issued by Yes Bank worth ₹-8,415 crores. 

When a bank falls, bondholders are often prioritised over shareholders. The bondholders in the Credit Suisse case won’t receive any compensation, but the shareholders will.

Due to the hierarchy issue, panic has spread among bond investors at the other institutions. The main reason why the shareholders will receive compensation and the bondholders won’t is because Credit Suisse has not traditionally declared bankruptcy. Without going through the bankruptcy process, other banks took control of it. Therefore, in this instance, the general bankruptcy rules did not apply.

Investors in AT-1 were apparently told by the Bank of England and European Union banking regulators that, in the case of a future bank crisis, they would take precedence over shareholders.

Clarification on Issuance of Perpetual Debt Instruments (“PDIs”) Overseas

Basel III Capital Regulations – Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital- Eligible Limit for Instruments Denominated in Foreign Currency/Rupee 

Denominated Bonds Overseas

Several banks have contacted the RBI to inquire about the maximum amount of capital that can be raised abroad. The matter has been looked into, and it is made clear that the “eligible amount” for purposes of issuing PDIs in foreign currency as per the aforementioned Master Circular’s para 1.16 (ii) of Annex 4 would mean the greater of: 

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The term “eligible amount” in this regard shall mean the higher of 

  1.  1.5% (one point five per cent) of Risk Weighted Assets (RWAs); and
  2. Total Additional Tier 1 capital as of March 31 of the previous financial year.

The amount of capital that can be generated internationally through the issue of PDI in Additional Tier 1 capital has been made clear by the Reserve Bank of India (“RBI”)[1]. The following rules have been established in this regard: 

  • Eligible amounts, not more than 49%, may be issued in rupee-denominated bonds overseas and/or in foreign currency.

In light of this, sub-paragraph (ii) of paragraph 1.16 of Annex 4 to the aforementioned Master Circular from July 1, 2015, is changed.

All other provisions of the aforementioned July 1, 2015, Master Circular on Basel III Capital Regulations, as revised from time to time, shall remain in effect. The issuances, as mentioned earlier, must adhere to all applicable prudential standards and FEMA guidelines.

Illustration of the “eligible amount” that can be raised as per Paragraph 1.16 (ii) of Annex 4 to Master Circular DBR.No.BP.BC.1/21.06.201/2015-16 dated July 1, 2015, on ‘Basel III Capital Regulations

We estimate the bank’s RWAs as of March 31 of the previous fiscal year to be ₹ 1000 crore.

CasesScenarioThe maximum number of AT1 bonds that can be raised overseas (with foreign currency or/and in rupee-denominated bonds overseas)
Case I As of March 31 of the previous financial year, the bank had AT1 capital of less than or equal to 1.5% of RWAs.   As an example, on March 31 of the prior fiscal year, the bank had no AT1 capital.Equals ₹ 7.35 crore (49% of 1.5% of RWAs).
Case IIAs of March 31 of the previous financial year, the bank had AT1 capital that was greater than 1.5% of RWAs.   As an example, the bank had AT1 capital of 50 crores as of March 31 of the previous Financial year.Equals 49% of ₹ 50 crores, i.e. ₹ 24.5 crores (49% of total AT1 capital as it is more than 1.5% of RWAs).
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Advantages of PDIs

Some of the advantages of investing in perpetual debt instruments are given below:

  • Perpetual debt instruments typically offer higher yields than other types of bonds. Since return, or income, is the primary factor taken into account when making any investment decision, having a high return potential makes it an ideal investment goal.
  • Retirees who want to get a steady stream of regular fixed income are most likely to look at perpetual bonds because of their high steady income.
  • For investors, these debt instruments offer a reliable source of fixed income. Interest returns on perpetual debt instruments are ongoing because there is no maturity date. A steady income makes it easier to achieve financial objectives more quickly.
  • Another advantage is that it helps the investor avoid having to put up the time and necessary effort to identify a suitable new investment when their current bonds mature because there is no maturity date in perpetual debt instruments.
  • At the time of liquidation, perpetual bondholders are given preference when paying their obligations. Compared to shareholders, they are less likely to lose money if the business fails. 

Conclusion

Irrespective of the high risk associated with perpetual debt instruments, it is a suitable option for some investors. Before making an investment in these bonds, it is crucial that you conduct a clear market analysis and consider various factors regarding investments.

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