Everything you need to know about ABS
Additional Tier 1 bonds (AT1s) are part of a family of bank capital securities known as contingent convertibles or ‘Cocos’. Convertible because they can be converted from bonds into equity (or written down entirely), and Contingent because that conversion only occurs if certain conditions are met, such as the issuing bank’s capital strength falling below a pre-determined trigger level.
This ‘loss absorbing mechanism’ is the key difference between AT1s and regular bonds, and it means AT1s are typically the highest-yielding bank bonds investors can buy, since bondholders expect to be compensated for the additional risks.
After governments and taxpayers were required to bail out a number of big banks during the global financial crisis of 2008, regulators moved to increase both the quantity and quality of capital held across the banking system, and for European banks AT1s were a key part of this new regime.
Under a new global regulatory framework known as Basel III, banks were (and still are) required to hold a minimum 4.5% Common Equity Tier 1 (CET1) capital ratio (common shares plus retained earnings divided by risk-weighted assets (RWAs)), and a minimum 8% total capital ratio. However, it is worth noting national regulators typically set minimum capital requirements for each major bank individually, which tend to be significantly higher than these global minimum standards.
In order to meet the total capital requirement, banks were permitted to supplement their CET1 with around 1.5% of their RWAs in AT1 capital and around 2% in tier two capital. While US regulators were happy for banks to make swift use of a well-established market for preference shares to fill their AT1 bucket, European regulators set out to create their own ‘resolution’ regime, which led to the creation of specific AT1 bonds in 2013.
AT1s’ position in Basel III capital requirements
Source: BIS, Sep 2013. The list of instruments is not exhaustive and is included solely for illustrative purposes. For a complete list of instruments and associated criteria for inclusion in each of the three capital buckets, see BCBS (2011). The above shares of RWA represent the bare minimum capital requirements and do not account for any add-ons, such as the capital conservation buffer, the countercyclical buffer and the SIFI surcharge.
AT1 bonds have three basic features.
The first, and in our view most crucial feature, is the loss absorbing mechanism, which is ‘triggered’ when the issuing bank’s CET1 capital ratio falls below a pre-determined threshold. Typically this trigger is either at 5.125% or 7% CET1, depending on the national regulator. Once this trigger level is hit, the notes are automatically converted into equity or written down in full, depending on the terms of the individual bond documentation.
Second, regulators require bank capital to be permanent (i.e. perpetual) in nature, so AT1 bonds have no final maturity, and instead they are callable with regulatory approval. AT1s typically have ‘non-call’ periods of between five and 10 years, after which investors generally expect the issuer to call and replace the AT1s with a new issue. If the bonds are not called, the coupon resets to an equivalent rate over the underlying swap rate or government bond.
Third, AT1 coupon payments are non-cumulative and discretionary. Missed payments do not build up as an expense for the bank, and non-payment is also not considered a default or credit event.
The most common risks attached to AT1s are broadly aligned with the features above.
First, the most obvious risk is that a bank’s capital position deteriorates to such an extent that its CET1 ratio falls below the trigger level, meaning AT1 bondholders either lose their principal entirely or are left holding equity in a poorly capitalised bank. However, the largest European banks (and therefore the largest AT1 issuers) are generally very well capitalised; the average CET1 ratio across the sector in Q1 2022 was 14.98%1, meaning banks typically have large buffers above their AT1 trigger levels and it would require truly huge losses for them to be breached.
Source: Citi, TwentyFour, June 2022. The list is not exhaustive and is included solely for illustrative purposes only, it should not be seen as a recommendation or endorsement of those featured or any securities associated with them.
Second, banks can choose not to call their AT1 bonds at the end of the non-call period as expected, otherwise known as ‘extension risk’. In theory a bank can choose not to call the bonds and retain the capital in perpetuity, an equity-like feature of AT1s that makes them higher quality capital from a regulatory perspective. However, like all large bond issuers, banks rely on their ongoing relationship with investors for regular access to the bond markets; choosing not to call an AT1 bond as expected would almost certainly damage a bank’s reputation with investors severely and likely lead to higher borrowing costs going forward.
Third, AT1 coupons can be halted by regulators. Under a rule known as the Maximum Distributable Amount, or MDA, regulators can restrict a bank’s distributions (including AT1 coupons) if its CET1 capital ratio falls below a certain level, although just as with AT1 trigger levels, European banks generally maintain large buffers above the individual MDA thresholds they are given. Regulators can also halt distributions to trap capital in the banking system as a prudential measure in times of stress or when losses are building up. However, history has shown regulators prefer to halt other distributions such as share dividends and bonus pools before they resort to halting AT1 coupons, just as they did in response to the COVID crisis in 2020.
There is another important regulatory element investors need to consider, which is that a bank’s solvency is ultimately at the discretion of its national regulator (or the European Central Bank for EU banks). If a bank runs into serious trouble, regulators can declare a Point of Non-Viability to try to protect depositors, stem the losses and prevent contagion.
We have seen that European banks generally have CET1 ratios in the mid-teens; we think it is highly unlikely any regulator would let a bad situation carry on long enough for a bank’s CET1 ratio to fall to 7%, let alone 5.125%, so in practice it is likely that a bank’s Point of Non-Viability would occur with capital levels higher than the trigger levels embedded into AT1 securities. This is why it is important for investors to pay attention to the individual capital requirements set by national regulators for each bank, and to scrutinise annual stress tests very carefully.
Source: ICE BofA Indices, September 2022
Source: ICE BofA Indices, Bloomberg, 17th August 2022. Past performance is not a reliable indicator of current or future performance. It is not possible to invest directly into an index and they will not be actively managed.
Source: Bank of England, European Central Bank, data as of 31st March 2022