* Bank of India launches first Tier 1 bond from state-run lender
* Top domestic rating shows limits of Basel III in India
* Bonds likely to be bought by funds linked to other banks
By Manju Dalal
SINGAPORE, July 25 (IFR) - A landmark capital raising from India's state-owned banking sector has reignited a debate over the application of Basel III standards in the country's local financial market.
Bank of India launched a Basel III-compliant Additional Tier 1 bond on Friday that secured a surprising Triple A rating from a domestic agency - a grade typically reserved for risk-free securities.
The offering of a minimum Rs12.5bn (US$207m) in perpetual non-call 10-year bonds may have been structured and rated to appeal mainly to other Indian banks, however, adding to the uncertainty over the depth of demand for the new-style securities.
Basel III capital rules are designed to force subordinated creditors to absorb losses if the issuing bank runs into trouble. Often referred to as "bail-in bonds", the securities may be converted to equity or written down to zero, depending on local regulations and how the deals are structured.
Global rating agencies typically knock at least four notches off a bank's senior credit rating to signal the potential risks in these bonds. Yet Brickworks, a domestic agency, has rated BoI's bonds AAA, the highest possible rating and the same as BoI's senior credit rating.
The high rating gives lenders such as BoI a better chance of attracting investors to the new product, but it also points to a deep-seated belief in the Indian markets that the government will not allow any state-owned bank to fail.
India regularly injects capital into its public sector banks (including US$2.2bn in the last fiscal year), and has a long history of state-orchestrated bank rescues.
While banking regulators have publicly embraced Basel III rules designed to limit such bail-outs, few local investors expect they will risk a systemic crisis by declaring a state-run bank to be no longer viable.
"If the senior bonds and AT1s under Basel III rules get similarly rated in the local markets then it clearly indicates the limitation of Basel III regulations," said an analyst at a global rating agency.
A senior official at another state-run bank said he was surprised by the rating.
"It is good news for the state-owned banks to get their Tier 1s rated at Triple A," he said, before asking: "What should be the rating for our senior bonds? Triple A plus?"
A high rating on the Basel III bonds may make the securities palatable to certain investors. Pension funds, provident funds and insurance companies often are the key buyers of bank capital bonds, although the bonds are considered "high-risk" investments and these investors cannot buy them if they are rated below Double A plus.
BoI may place most of its AT1 bonds with state-owned bank provident funds, which would be investing in the bonds mainly as a show of support as they also may need to raise bank capital soon. According to RBI's initial estimates, Indian banks need to raise about Rs1.9trn of AT1 securities by March 2018.
If BoI does, in fact, sell the bonds to such a narrow, and self-serving, base, it raises questions about the ability to create a true domestic market for Basel III bonds in India.
"With a Triple A rating and a double-digit yield, the BoI bonds might certainly look enticing for the PFs, but is the deal creating the right market? I really doubt it," said a debt capital markets specialist at a foreign bank.
Investors are demanding a higher yield relative to BoI's senior and Tier 2 bonds. That suggests they see the AT1 securities as more risky, regardless of the top rating.
BoI is indicating its new-style bonds will have an 11% coupon, which is an 180bp pick up over the bank's Basel-III compliant Tier 2 securities.
In September, BoI sold Rs10bn of Triple A rated Tier 2 Basel III-compliant 10-year bonds at a 9.80% yield. The yields on those bonds have fallen to about 9.20% in secondary trading.
Such a high yield on a high-rated BoI bond might prove attractive, but many investors believe the new issue is still under-priced.
"For the issuer, these bonds are a 10-year paper but for investors it's a perpetual risk," an investor said. "Because of the permanent write-off feature there is no protection of even the principal amount. I strongly feel the deal was priced more on what the issuer was comfortable with rather than on its risk factors."
Indeed, BoI faced some resistance before agreeing to boost the yield 50bp to 11%, sources aware of the pricing said. The Basel III perpetual bonds are structured to write down to zero, rather than convert to equity, if the bank is declared to be not viable.
Still, market participants believe the deal may complicate efforts to determine the right price for senior bonds in the future.
"Since the pricing of bank bonds in India is not reflecting the true risk, it is not creating the right yield curve," said a Mumbai-based DCM banker. "This is totally detrimental to the industry."
BoI may also tap the offshore market for additional capital, a route state-owned IDBI Bank is likely to take. IDBI discussed a potential US$300m Basel III-compliant AT1 offering with overseas investors in non-deal roadshows held earlier this month.
BoI had planned to sell a US dollar-denominated US$400m AT1 bond in January, and had even mandated seven arrangers. The bank was considering sell the bonds with an aggressive 8.5% yield, but it faced resistance from investors who could earn a similar return on much higher-rated European issues, sources said.
Axis Bank, Darashaw, ICICI Bank and Trust Capital are equally underwriting BoI's AT1 bond. The size of the deal, which remains open until August 8, could double if BoI exercises a greenshoe of Rs12.50bn. (Reporting by Manju Dalal)