AT1 bond

Banks must hold capital against their risks, and Basel III sorts that capital into layers. An AT1 bond sits in the top layer alongside equity, even though it looks like a bond.

The workbook's explanation: under the Basel III framework, banks' regulatory capital is divided into Tier 1 and Tier 2. Tier 1 is subdivided into Common Equity (CET1) and Additional Tier 1 capital (AT1). Equity capital is CET1. Perpetual bonds that satisfy specific conditions stipulated by RBI are classified as AT1.

They are, in the workbook's words, a type of unsecured, perpetual and non-convertible bonds that banks issue to shore up their core capital base to meet the Basel-III norms.

The word to hold on to is capital. An AT1 bond pays interest like a bond, but a bank issues it to count towards its core capital base.

Where AT1 sits.

AT1 against its nearest neighbour, the Tier 2 bond, both from the same section of the workbook:

Seniority and yield. The workbook explains that bonds lower in the priority of claims offer higher yields to compensate for the risk, and that even the bank's Tier 2 bonds are subordinated to depositors, unsecured creditors and senior bonds. It does not set out a full liquidation ranking for AT1, but its features — unsecured, perpetual, counted as core capital with equity — are the opposite of what a depositor holds.

Illustrative bank, amounts and coupons.

A bank needs to raise its Tier 1 capital. It weighs three routes for Rs 1,000 crore:

The AT1 issue raises Tier 1 capital without issuing new shares. The assumed coupon is higher than on the Tier 2 bond, consistent with the workbook's rule that instruments lower in priority pay higher yields.

Now the investor's side. Mr Sinha buys Rs 10 lakh of the AT1 bonds for the 8.50 percent coupon — Rs 85,000 a year. What he holds is:

• unsecured — no specific assets back it;
• perpetual — no maturity date on which he is entitled to his Rs 10 lakh back;
• non-convertible — no route into equity;
• core capital of the bank, counted with its equity.

The workbook places even the bank's Tier 2 bonds behind its depositors. An AT1 bond is not a better-paying deposit; the extra coupon is compensation for holding something very different.

Chapter 1 (Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Markets) describes AT1 bonds in section 1.3.7 on other instruments, directly followed by AT2 (Tier 2) bonds, and explains seniority and subordinated debt in section 1.3.6. Expect a question on how Basel III divides Tier 1 capital, and on the three defining features of AT1 bonds — unsecured, perpetual, non-convertible.

• AT1 is Tier 1 capital, not Tier 2. Tier 1 = CET1 (equity) + AT1 (qualifying perpetual bonds).
• Unsecured, perpetual, non-convertible — all three.
• Tier 2 bonds have a minimum 5-year tenor, no put, and a call only after 5 years with RBI approval. Those are Tier 2 features, not AT1 features.
• Equity is CET1, not AT1.
• Only perpetual bonds satisfying RBI's specific conditions qualify as AT1.
• An AT1 bond is not a deposit. It is bank capital, and junior in priority.