Are smaller AT1s still offering sufficient premium?

This week a small Austrian lender, KommunalKredit, brought to the market a €150m Additional Tier 1 (AT1) transaction. The deal, rated B+ by S&P, started off with initial price thoughts (IPTs) at 9.25%, attracted an order book of €300m and was ultimately priced at 9.0%. That represents a spread of 580 basis points (bp) over Bunds, which still compares favourably to similarly rated bonds in the high yield market.

This latest transaction follows several sub-benchmark size deals priced in the AT1 market this year, accounting for around 5% of total issuance year-to-date in this space. We approach these deals as we do any other fixed income investment; with our eyes and minds open with the aim of performing an unbiased credit and relative value assessment. Indeed, in the past we have participated in a number of smaller AT1 deals from lower tier banks where we felt the spreads justified the risk. Currently, we do not think premiums for this type of off-benchmark deal are offering adequate compensation for the move down in credit quality.

Generally, we look at these deals through three lenses.

First, we compare the transactions to the broader AT1 sector. Four or five years ago, sub-benchmark size transactions typically offered spreads and resets that were considerably higher than those of major banks. As an example, in September 2021 when the AT1 market was hot, UK specialist buy-to-let lender OSB brought a £150m AT1 deal at a spread of 540bp over five-year Gilts, while a £150m transaction from Shawbrook was trading at 950bp over Gilts. The two deals were offering a spread pick-up of around 220bp and 630bp respectively over a comparable benchmark size transaction from NatWest, therefore providing healthy upside for the drop in credit quality, given OSB’s AT1 was rated two notches below Natwest and the Shawbrook deal was unrated.

Fast forward to 2026, and these three lenders have returned to the AT1 market to refinance their deals. NatWest’s rating has improved by between one and four notches (depending on the rating agency), OSB is rated one notch higher and Shawbrook remains unrated. NatWest has a transaction callable in 2032 currently trading at a spread of Gilts+255bp, while OSB is trading at Gilts+345bp and Shawbrook at Gilts+415bp. In other words, the NatWest-OSB spread has compressed from 220bp to 90bp (for a drop from BBB to BB- rated risk), while the NatWest-Shawbrook spread has collapsed from 630bp to 160bp.

The relative lack of premium on these smaller transactions is even more glaring when we consider the all-in yields that these transactions offer. Following the move higher in government bond yields, the NatWest deal is showing a yield of 7.6%, the OSB deal 8.3% and the Shawbrook deal 9.15%.

Second, we overlay the AT1 space analysis by looking at the capital structure more broadly. Many of these small issuers have business models which carry naturally higher risks, for example – a niche market presence, lower capacity for risk controls, more concentrated single sector exposure, or little systemic relevance from a support standpoint. As a result, we believe equity investors in these banks – often private equity firms – will require returns of equity to the tune of 15-20% over the period of their ownership. This is considerably higher than the cost of equity implied by the valuations of the European banks’ equity index, which is currently around 10% (based on the latest average return on equity of 13.3% and a price-to-book ratio of 1.44x). This is also based on the returns some of these specialist lenders have been achieving (low-to-mid double digits), with listed equities trading below their book value.

In other words, looking at the capital structure more broadly, we would expect the AT1s of some of these lenders to deliver 11-13% type coupons given the current implied equity valuations.

Finally, we compare AT1 relative value against other asset classes. Given the B+ rating of KommunalKredit, the most obvious comparison is B+ rated bonds in euros. The single-B corporate bond index in euros is currently yielding 7.6% and is one notch lower than KommunalKredit’s newly issued 9% bonds. While optically this premium looks attractive, the reality is that a) we are not so keen on single-B high yield corporate risk at the moment b) recovery rates in AT1s are expected to be lower than senior secured high yield debt, and c) off-benchmark AT1s tend to have lower liquidity than a high yield index eligible bond. In other words, maybe the probability of default is lower for a regulated bank such as KommunalKredit compared to a single-B corporate issuer, but loss given default also needs to be considered.

This is not to say that we will not participate in certain transactions where we see value in individual lenders and scope for improvement in fundamentals over time. We are however being extremely selective given credit availability to the banking sector AT1 deals has arguably never been higher, and in the current environment we favour capital preservation over targeting the dwindling upside being attached to greater credit risk.