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First Asian Basel III bonds underscore lack of knowledge

* Bail-in bonds in India and Australia come with low yields

* Investors ignore higher loss risks of new securities

* Regulators trying to enforce investor education

By Manju Dalal and John Weavers

June 28 (IFR) - As the first bank bonds that comply with new Basel regulations start to be printed in Asia, the results they are achieving underscore the lack of understanding by local investors of the risks the new securities involve.

This week, the United Bank of India sold the first bond that is eligible to be used as Tier 2 capital under the new banking framework. The lender managed to pay just a small premium over its outstanding subordinated bonds denominated in rupees, unlike what has been happening in global markets.

The difference, however, is that the new bonds include a clause that converts them to equity if the bank's core equity Tier 1 capital falls below a level yet to be defined by regulators, effectively wiping out investors to keep the bank afloat. Meanwhile, the old bonds would only be scrapped in the case the bank became insolvent.

A similar story is unfolding in Australia, where Westpac is expected to launch its first local Tier 2 subordinated bonds that comply with Basel III regulations next week.

According to bankers in Sydney, the lender is looking at issuing the new bonds at a similar spread to where its old subordinated bonds trade in the secondary market. Again, that means that Australian investors seem to be requiring no additional yield for the added risk of loss-absorption clauses.

One banker that specialises on financial institutions explained that local currency deals have always shown smaller premiums between senior and subordinated debt.

"These deals have large retail components, and local investors base much of their buying decisions on name recognition," he said.

REGULATORY CONCERN

However, he said that regulators are showing concern that investors may not be fully appreciating the much higher risk of loss embedded in the new structures.

"There are ongoing discussions to limit who can buy new subordinated bonds going on in the Hong Kong Monetary Authority, at the Monetary Authority of Singapore. Even the Bank for International Settlements (which establishes the Basel guidelines) is getting worried," he said.

Indeed, Thai regulators recently ruled that retail investors would not be allowed to buy new subordinated bonds. The central bank of the Philippines also said it will require buyers of such paper to sign a letter stating they understand the risks that the security carries.

India's case shows the lack of understanding may not be limited to retail investors.

United Bank of India's INR5bn (USD86.2m) new 10-year bond -which includes bail-in clauses - was sold directly to state-run Life Insurance Corp of India with a coupon of 8.75%. At that level, it offered a premium of only 50bp over UBI's old 10-year Tier 2s, which were trading around 8.25% in early June.

"The Indian market is unique. While internationally, Basel III-compliant sub debt is ranked a notch lower and a premium is expected for the loss-absorption features, Indian markets are not acknowledging these factors at all," said a DCM official at a foreign bank.

Indeed, in India, even the ratings agencies seem to be misreading the risks of the new bonds. UBI's new sub debt has been ranked AA+ by local agencies Crisil and Brickwork, putting on a par with the bank's existing Tier 2 bonds, which do not include loss-absorption clauses.

WORTHLESS EITHER WAY

Australian investors also seem to be comfortable with the risk of losing their money to keep the issuing bank afloat.

Price whispers for Westpac's upcoming new-style Tier-2 bond has been heard at 200bp-220bp over bank bills, whereas its old-style notes are quoted at 220bp-230bp over in the secondary market.

"The chance of Westpac going bust is effectively zero. But even if it did, the consequences for both notes would be the same. There will be no equity value left for new-style noteholders, while old-style Tier 2 notes will become worthless," said a banker not involved in the deal.

Philip Bayley, principal at ADCM Services, disagrees. "In reality, these new-style notes should pay a premium since they rank behind existing subordinated bonds because of the conversion trigger. Consequently, they would be wiped out before the old-style bonds in the event of bankruptcy - however unlikely this is."

Bayley believes retail support will be "critical" for Basel III-compliant notes, since their non-viability triggers take them outside the mandate of many institutional investors. Previously, banks issued subordinated bonds in the wholesale market.

He is concerned that retail investors do not understand the risks involved with the new instruments, although this has not prevented their eager participation in previous Basel III-compliant deals, including Westpac's own AUD1.25bn Tier 1 hybrid in February.

Bayley's concern is no novelty for the Bank of International Settlements. Back in 2003, BIS researchers Urs W. Birchler and Diana Hancock, who at the time were members of the Swiss National Bank and the Federal Reserve, respectively, wrote a paper underscoring the effects of poor understanding of subordination risks in bank debt.

In it, the authors argue that there are two kinds of buyer of subordinated debt: informed and uninformed investors. The first category, requires a premium for the added risk of incurring higher losses in the case of a restructuring. At the same time, the authors concluded that this premium is reduced as the public perception of the bank's risk of failure drops.

In other words, the better the name recognition, the lower the spread. The trouble is that Asian local investors seem not to understand that they could now lose their money way before the bank actually fails. And if regulators just stand aside, by the time they learn the difference, it may be too late. (Reporting By Manju Dalal and John Weavers; editing by Christopher Langner and Philip Wright)