Indian banks are queuing up to raise Additional Tier 1 capital after the Insurance Regulatory Authority of India (IRDA) last week permitted insurance companies to invest in Basel III-compliant AT1 bonds for the first time.
IRDA has allowed insurers to invest in AT1 rupee bonds with local ratings of AA and above, opening up a new source of demand for the subordinated securities after a long wait.
Last week, private-sector lender Axis Bank priced an AT1 offering with a call option after five years (non-call five) at 8.75 percent. It is said to have raised 30 billion rupees ($445 million) and insurance companies are heard to have picked up nearly 2 billion rupees of the bonds. Axis has yet to make an official announcement on final price, size and tenor.
Vijaya Bank, a mid-sized public sector lender, also said it intended to raise 7.5 billion rupees from AT1 instruments. Bank of Baroda recently printed 10 billion rupees of AT1 bonds at 8.5 percent.
"Now, there is demand from insurers, besides mutual funds, banks and institutional investors," said a Baroda source. "Banks are able to down-sell these bonds," he said.
Banks benefit from the wider investor base, and it also allows insurance companies to take advantage of the yield pick-up.
"Given the interest rate environment, one would naturally expect demand from the insurance industry. At higher yields, one is able to lock in for a longer term," said S Gopalakrishnan, chief investment officer at ICICI Lombard General Insurance.
Double A rated AT1s are priced close to 9 percent, compared to AA corporate bonds, which offer a yield of 7.56 percent for a five-year tenor, according to Thomson Reuters data.
"Insurance companies will go through the process of amending their investment polices, etc" to allow investment in such instruments, Gopalakrishnan said.
The insurance regulator has eased rules for investments in AT1 bonds at a time when banks need to shore up their capital levels. Fitch estimates that Indian banks will require $90 billion in new capital by FY19 to meet Basel III requirements, of which close to $30 billion will come from AT1 bonds.
While some incremental demand is expected to pour in from the insurance industry, analysts feel that stringent guidelines might reduce the scope of investment.
"There are not too many banks that can achieve AA ratings for their AT1 bonds, and the list is possibly restricted to about the top few large banks," said Saswata Guha, director at Fitch Ratings.
Under the IRDA guidelines, AT1 investments are treated as equity. Therefore, insurers like Life Insurance Corp of India, which already has large exposure to a particular bank's equity, may be reluctant to invest in an equity-like structure which offers returns of 9-10 percent. State Bank of India's shares, for example, have already gained 17 percent this year.
LIC's exposure is already close to the 15 percent cap it can hold in most of the state-owned banks, according to Prime Database.
"It limits the scope in terms of how much demand for AT1 may come from the insurance route," Guha said.
IRDA guidelines say that individual insurers cannot invest more than 10 percent in a single bank's AT1 issue. For example, if the issue size is 10 billion rupees, each insurer can invest only up to 1 billion rupees.
Some analysts feel that limit could lead to better price discovery as banks will have to use the electronic bidding process to place the bonds with multiple investors, compared with earlier bilateral deals placed to mutual funds.
Still, insurers are wary of being seen as easy targets for banks looking to raise cheap capital. Given the loss-absorbing features of AT1 bonds, some insurance fund managers are not comfortable buying these at such low yields.
Some have also flagged concerns that the pricing of AT1 bonds in the domestic market in the recent past is much closer to senior debt than in the overseas market, as foreign investors demand a higher premium for the risk of unpaid coupons, equity conversion or principal write downs.
"When the system is surplus with liquidity, the risk on such instruments will not be adequately factored in. This is what happens historically," said Aneesh Srivastava, chief investment officer from IDBI Federal Life Insurance.
The banking system is flush with liquidity after the government last month banned old 500 and 1,000 rupee notes in a crackdown on unreported savings, or black money.
"For insurance to buy AT1 bonds will not be easy in the current environment as there is uncertainty surrounding coupon payment ability of banks," said Srivastava. "We are in a long-term business; we don't want to take any risk on returns that we want to earn."
IRDA has also said that insurers can only invest in bonds from banks that have declared dividends for the preceding two years, in line with its requirement for equity investments. Among India's major public sector banks, only State Bank of India, Union Bank, Oriental Bank of Commerce, Andhra Bank and Punjab and Sind Bank have paid dividends in 2015 and 2016, according to Kotak Institutional Equities Research, which rules out most of the public sector banks in the near term.
While allowing insurers to invest in AT1 bonds increases the depth of the market, a sizable portion of banks' capital demands will still have to come through other means.
"Banks, at some point, have to start looking at the international market if they have to fulfil their AT1 requirement, through either dollar issuance and/or through the Masala bond route," said Guha of Fitch.