Indian banks will have to contend with a number of hurdles if they want to issue Basel III-compliant bonds both in their local markets as well as overseas, according to credit analysts and bankers.
In the international markets, the problem arises from the fact that old-style Basel II bonds have traded wider because of issues with illiquidity and the risk that banks may not call back their bond.
This concern is based on previous experience. ICICI Bank distressed investors last year after failing to call their Tier II securities maturing in 2020 and instead announced an exchange offer to a new Tier II bond. But that proposition flopped as investors felt that the bank did not provide enough compensation and since then, it has heightened concern among investors that Indian banks may not call their bonds in the future.
“Some people are convinced that they [the Indian banks] will leave them [bank capital bonds] outstanding and never call them, and that will be cheap senior funding for them. That’s why old-style bank bonds trade very wide relative to the rest of the sector,” according to the credit analyst. “India out of all countries is the least well-received in terms of bank capital because they don’t have a good track record and they don’t have much of a track record in terms of their behaviour towards bondholders. At least to the old-style capital securities, Asia is very sensitive towards the way that banks are behaving.”
The other issue is that there are not enough bank capital securities outstanding from Indian banks in the offshore markets, which makes it less liquid. For example, only about US$3 billion of US dollar-denominated Tier II bonds are outstanding, according to Dealogic. That is only a fraction of the total INR8 trillion (US$147 billion) in Tier I and Tier II bonds in both local and other foreign currencies outstanding as of March 2012, according to Reserve Bank of India figures.
A combination of these factors contribute to the fact that bank capital securities issued by Indian banks trade at the widest spreads compared to their Asian peers in the US dollar-denominated secondary market. For example, ICICI, which is rated ‘Baa2’ by Moody’s and ‘BBB-‘ by Standard & Poor’s, has lower Tier II bonds maturing in 2020 that trade at 6.5%. That compares with the 3.5% yield paid by South Korea’s Woori Bank’s lower Tier II bond maturing in 2021. The South Korean bank is rated ‘A1’ by Moody’s and ‘A-‘ by Standard & Poor’s.
Given that India banks’ subordinated capital trade in the 7% range, the new-style Tier II bonds will have to be priced in the very high single digits at a minimum. This is particularly the case because the new-style bonds include loss-absorption features, which require outstanding bonds to be converted to equity or have their principal written down to zero if a bank is deemed “non viable” by a country’s financial regulators.
This option is considered a risk and concerns investors. The government has announced that Indian banks will require capital injections in the coming years to meet Basel III requirements. Indian banks will need US$60 billion from external sources in the next five years to meet Basel III requirements, according to CLSA.
“There’s a concern that if the government has to inject money in the banks, then the securities will be written off before the government will do so. The wording on that is still vague for Basel III with some of these securities specifically on where you actually are in the capital structure and the order of events. That adds a lot risk and with the loss absorption features, India is in the weakest position right now.”
As of March 2012, Indian banks’ Tier II capital stood at 3.9%, compared to the RBI’s standard of a minimum 3%. Indian banks do not have an immediate concern to fund their bank capital immediately this year and in 2013, but a bulk of Tier II capital will start maturing in 2014.
The additional concern of a sovereign downgrade has added volatility in the Tier I securities in secondary trade. A downgrade is expected to come in the second quarter and will make it even more challenging for Indian banks to come to the market, said another analyst.
That’s why it may make sense for Indian banks to tap the local markets instead.
“It’s going to be expensive for them to issue bank capital bonds in the offshore market,” said the analyst. “The locals will buy them first since regulations behind the international bond market are not as lax so the incentive is there to start locally.”
Tapping onshore investors
Another banker based in India agrees that issuing subordinated bank capital in the local markets may be more cost-effective. At least for a Basel II-compliant Tier II bond, Indian banks can issue a rupee bond at around 9%, which would be as much as 200 basis points cheaper than an offshore Tier II bond. This will probably the case for Basel-III complaints bonds, said the banker.
Foreign investors will also be charged a withholding tax if the banks issue the bank capital bonds from their Indian entities rather from offshore entities. But offshore entities will have to adhere to Basel III rules in the jurisdiction of where the offshore entity is based, and those restrictions are still being ironed out.
Still, investor sentiment even in the local markets has not been favourable to Basel III-compliant bank capital securities. Central Bank of India, Oriental Bank of Commerce, United Bank of India and ING Vysya Bank have tried and failed to sell Basel III-compliant bonds in the past few weeks, according to the Business Standard. But the banker says this has been a function of the lack of education on part of both the issuer and investor is needed.
Although Basel III-complaint bank capital securities may include a premium when issued, the fact that Basel III rules requires all subordinated Basel II bonds to amortise by 10% a year means that the new-style bonds may not be as expensive as some investors fear.
“If it’s being phased out 10% each year and you are talking about a 10-year instrument, you ‘ll already be paying 100 basis point-premium to where a Basel II would price,” said the banker. “Once this option of not issuing Basel II goes out from the market and more issuers are forced to issue Basel III, the issuers will be willing to pay a higher price and the investors will be more willing to spend time to understand these loss-absorption features. Then the market should pick up.”
Currently, Asian banks are considering 10 non-call 5 features as a possibly structure for the new-style bank capital bonds.