How robust are CLOs through a recession?
As we start the new year and approach the 5th anniversary since the issue of the first European Additional Tier 1 (AT1) bond (BBVA 9% Perp-18), it is a good time to re-assess the sector in the current market.
The inaugural BBVA 9% mentioned above reaches its first call date in May of this year and looks set to be called, given it has a reversionary rate of 5yr US Swaps + 8.262% i.e. this is the rate that the new coupon will be reset to if the bond is not called. This is much higher than what BBVA would currently have to pay to issue a new AT1, and hence we expect that the borrower will elect to refinance (and we presume the regulator will concur). The bond is currently trading at a 2% Yield-to-Call, having delivered a total return of 50% to its happy holders since it was launched in April 2013.
Being the first deal out of the blocks, BBVA were forced to issue at a very attractive spread; it effectively marked the launch of a brand new sector, where a buyer base had yet to be established and which promised a flood of new issuance from a plethora of banks that needed to increase their capital levels. Add to this the fact that most banks were still in the process of repairing their balance sheets, and from a fundamental credit quality viewpoint still had hurdles to overcome, and it is no wonder that all of the early deals were issued with very attractive spreads, and in turn, with very high reversionary reset rates.
Fast forward to today and we are in a very different position. From a fundamental perspective, most of the banks have now repaired their balance sheets and are arguably better capitalised now than they have ever been in the past. In addition to this the “technical” drivers for the sector have changed from being very challenging to now being very supportive. The deluge of new issues that followed BBVA back in 2013 has resulted in a current stock of secondary issues of approx. €145bn of benchmark AT1s; however, as the major banks reach their maximum AT1 capital threshold (1.5%) the supply has dried up considerably with only €20-25bn of issuance is expected this year (including c.€10bn of refinancing deals). This net new issuance number of €10-15bn for 2018 is likely to be easily absorbed by the broad-based buyer base that has been established in the last 5 years, and hence demand is likely to easily outstrip supply.
In addition to the strong technicals, the spreads available are also still attractive in this low yield environment and the AT1 sector is one of the only areas within fixed income where we believe investors can reasonably expect further spread tightening in 2018. However, after spreads tightened by over 100bps in 2017, why should investors be comfortable with this prediction? Part of the answer comes from the high reversionary rates that these securities were issued at. Excluding the most recent new issues, the reset rates on the majority of the earlier deals are at much higher levels than where the bonds are currently trading at, and therefore most of these AT1s are comfortably trading to the call date, as bullet maturities. This has been a very important development in the AT1 market over the last 12 months, because they now trade similarly to other bonds, rolling down the credit curve, with investors demanding lower spreads as the maturity shortens.
Being able to position yourself in short dated AT1s, that not only offer attractive yields, but also give the protection that short duration bonds typically do and benefit from rolling down the curve is a very significant development for AT1 holders and for the sector. Obviously, AT1s will not be immune to general volatility in credit markets, but compared to 2013, investors are enjoying much better fundamentals, continued attractive spreads, albeit at tighter levels, and much better technicals, both as regards supply/demand and the maturity certainty of the bonds.
Unsurprisingly, AT1s continue to be one of our favoured sectors for 2018.