Everything you need to know about AT1s/CoCos

White Paper

Since their inception in 2013, Additional Tier 1 (AT1) bonds have developed into a $200bn plus multi-currency asset class that, with a high level of due diligence, can offer an attractive opportunity for fixed income investors facing another decade of ultra-low yields.

In TwentyFour’s view:

• European banking sector fundamentals have become increasingly more regulated and ‘utility-like’, and look attractive for bond investors.
• AT1s offer an attractive risk profile, with the potential for high yields relative to other areas of fixed income. Despite being subordinated some of the bonds available in this sub-sector are investment grade and the vast majority are issued by large and well-capitalised lenders.
• A T1s look to have passed a key test so far in 2020, as the COVID-19 crisis led regulators to restrict bank dividend distribution and share buybacks, while actively supporting the payment of contractual AT1 coupons.

What are Additional Tier 1 (AT1) bonds?
AT1s are ‘going concern’ hybrid debt. After the global financial crisis of 2008, regulators set out to end ‘too big to fail’ and thereby support tax-payers by increasing both the quantity and quality of loss-absorbing capital in the banking system; AT1s are a key part of that new regime. To support their risk-weighted assets (RWAs), the post-crisis Basel III regime permitted banks to issue AT1 (capital contingent) debt as part of their overall capital. A maximum of 1.5% is permitted in AT1 bonds and 2% of RWAs can be supported by Tier 2 (T2) capital bonds. Both of which sit above Core Equity Tier 1 (common shares plus retained earnings).

CoCos’ position in Basel III capital requirements(1)

Source: BIS, Sep 2013
1. The list of instruments in this graph 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

While US regulators were happy for banks to make swift use of a well-established market for preference shares to fill these new capital buckets, European regulators set out to create their own ‘resolution’ regime that would help ensure a failing institution had enough ‘bail-inable’ debt to be recapitalised without the help of the taxpayer.

This culminated in European banks issuing specific AT1 bonds, also known as Contingent Convertible bonds or ‘CoCos’.

Like preference shares, AT1 bonds are callable securities and are typically issued in perpetual format; typically with non-call periods of between five and 10 years. However, the crucial feature of AT1s is their loss absorbing mechanism, which is ‘triggered’ when the issuing bank’s CET1 capital ratio falls below a pre-determined threshold. Once the trigger level is hit – this happens at 5.125% CET1 for ‘low trigger’ AT1s and 7% CET1 for ‘high trigger’ versions – the notes are either converted into equity or written down in full, depending on the terms of the individual bond documentation.

AT1 bonds in 2020

TwentyFour participated in the very first AT1 transaction – Spanish bank BBVA’s $1.5bn perpetual non-call five, which carried a coupon of 9% – and in the years since we have seen the asset class grow through initial investor scepticism to become established, normally liquid and increasingly global; around $220bn of AT1 debt is currently outstanding and is mostly split between dollars, euros and sterling, though smaller banks in Europe, Asia and EM have also done deals in their domestic currencies.

With the unprecedented stimulus unleashed by central banks in response to the COVID-19 pandemic, in our view interest rates look set to remain anchored at or near to zero for many years, and investors will again be challenged by yield becoming an ever scarce commodity.

As such, we expect fixed income investors will be looking to sub-sectors such as AT1 to try to inject some additional yield into their portfolios. We believe this to likely to gather pace as the robustness of bank balance sheets is tested, and ultimately we believe proven, through the recessionary period brought about by the COVID-19 pandemic. Banks were at the centre of the global credit crisis in 2008/9, whereas in the current crisis it is gradually being realised that banks can be a part of the solution to help aid the recovery.

Facing this environment, we believe the AT1 market is one bond buyers in both Europe and the US can no longer afford to ignore.

ICE BofA Contingent Capital Index (COCO) Face Value and Yield to Worst, 2013-2020

Source: TwentyFour, Bloomberg, 30/07/20. Past performance is not a reliable indicator of future performance. Investments, including any income from them, can go down as well as up due to market and currency risks meaning investors may get back less than they invested. It is not possible to invest directly into an index and it will not be actively managed.

First, AT1 is one of the highest yielding sectors in the global bond universe.
Yields on European bank AT1s vary significantly depending on the size, geography and perceived quality of the institution, as well as the structure of the AT1 bond itself. The yield range in this diverse sub-sector is typically between 4% and 10%, and can offer attractive opportunities compared to other credit sectors; compared to the yields on high yield corporate bonds of the same rating, we often see a premium and relative value here. The widespread disruption of the COVID-19 pandemic means the path of the economic recovery remains very uncertain, and projections for corporate defaults are equally murky. Given that backdrop, in our opinion the extra visibility of bank earnings helps to give bank capital securities an added advantage over high yield alternatives.

Second, European bank fundamentals look increasingly attractive to fixed income investors.

In recent years investors have, in our view correctly, been wary of European banks’ equity story; the sector has been subdued by low interest rates and left behind by more profitable US rivals. However, for bondholders we believe the picture looks far healthier. Having withdrawn from riskier activities and issued billions of dollars’ worth of regulatory capital, European bank balance sheets now look to be more robust than they have ever been, with the average CET1 ratio across the sector now more than triple what it was a decade ago. Big UK lenders such as Coventry Building Society and Nationwide Building Society, for example, have AT1 bonds trading at yields in excess of 5%, despite being among the most highly capitalised institutions in the global banking sector, and despite their revenue base being focused purely on ‘boring old’ mortgage lending. The favourable comparison with unregulated high yield sectors of the market are obvious in our view.

Third, AT1s have so far proven their resilience in 2020.

While regulators quickly moved to restrict bank dividends and share buybacks as the economic chaos wrought by COVID-19 became clear in March, contractual AT1 coupons have continued to be paid. The ECB has recently taken this a step further by recommending banks restrict any dividend distribution or accrual until at least the first quarter of 2021, along with a recommendation to be “moderate” with variable employee compensation. This reduction in distribution effectively adds to banks’ retained earnings and enhances their CET1 ratios, thereby increasing the protection for subordinated bondholders, who continue to receive their coupon payments.

Conclusion

We appreciate why there is a degree of complexity premium associated with AT1 bonds, and in our view investing in the sector certainly requires extensive due diligence on the individual bonds, particularly around the optionality of the call structure for the issuer. However, we ultimately believe AT1 is an asset class that is largely under-utilised by bond investors, particularly those in the US who understandably are drawn towards the preference shares of their own strong domestic institutions.

At a time when central bank action is helping to create an environment where yield is looking likely to be a scarce commodity, over a protracted period of time, we believe AT1s should be an integral part of the allocation for all those bond investors looking to boost their portfolio yield.