50 or 75? Across the board - both are live
Dillon Lancaster evaluates the impact of Powell’s Jackson Hole speech on inflation and why he believes next month is set to be a very important period for central bank meetings.
We believe engagement should be a constructive, active dialogue between investors and companies on all aspects of their ESG performance.
While fixed income investors do not have voting rights in the way shareholders do, larger firms typically issue bonds multiple times a year, which puts bondholders in a strong position to be able to influence corporate policy by engaging with management on an ongoing basis.
At TwentyFour we aim to engage regularly with the management of every issuer whose bonds we hold in our portfolios, to better understand their ESG strengths and weaknesses, monitor their direction of travel, and overall encourage better ESG practices.
As part of our commitment to the UK Stewardship Code we publish a quarterly summary of our engagements with bond issuers, along with details of any resulting investment decisions, at the bottom of this page.
ESG investing is a fast-evolving discipline, and approaches can vary markedly from manager to manager. We therefore believe this makes the quality of the ESG data used in different scoring systems critical to outcomes, and even more so in fixed income, where we think data provision is improving but still well behind the level we see in the public equity markets. Because of this, we regularly engage with our external data providers and push them to extend their output.
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.
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 Q4 2023 was 15.73%1, meaning banks typically have large buffers above their AT1 trigger levels and it would require truly huge losses for them to be breached.
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.
1https://www.bankingsupervision.europa.eu/press/pr/date/2024/html/ssm.pr240410~893f0389e1.en.html
Asset-backed securities (ABS) are a type of bond, typically issued by banks or other lenders.
What makes ABS different to conventional bonds, such as government or corporate bonds, is that they are ‘secured’ against a diversified pool of loans with similar characteristics.
This collateral pool will typically contain thousands of assets such as mortgage loans, and the interest and repayments on those assets are directed straight to investors in the bonds.
This is where the phrase ‘securitisation’ comes from – investors’ coupons are secured by the cash flowing from the regular repayments on the loans included in the pool. In other words, the credit risk in ABS transactions is limited to the quality of the assets.
Asset | Thousands of assets with regular repayments and similar characteristics, such as mortgages or car loans, are pooled together. |
|---|---|
Backed | The company issuing the ABS sets up a legally separated Special Purpose Vehicle (SPV), which purchases the asset pool. The bonds investors buy are backed by the interest and principal proceeds from the asset pool, and ‘bankruptcy remote’ from the bank or lender. |
Securities | The company sells bonds – or securities – via the SPV to investors, who are paid directly from the repayments on the assets in the pool. |
At first glance, the ABS market can look like a confusing alphabet soup of acronyms (RMBS, CMBS, Auto ABS) but they simply identify the assets backing the bonds – for example residential mortgages (RMBS), commercial mortgages (CMBS), car loans (Auto ABS).
ABS is one way banks and other lenders fund their businesses. Their motivation for doing so is no different to that of any government or company issuing a regular bond – to borrow money against future revenues.
The difference with ABS is that it funds a specific pool of assets, and is backed by the proceeds from those assets, instead of the general financial strength of the issuing company.
For the issuer, one big advantage of ABS is that it offers ‘matched funding’ or ‘term funding’ – instead of selling normal corporate bonds to investors and then distributing the funds around the business, ABS funds a specific part of the balance sheet for a specific period of time.
For the ABS investor, the advantage is you are effectively being paid by the pool of loans backing the bond, rather than the company you are buying the bond from. If the issuing company was to go bankrupt, your coupons would continue to be paid, since the underlying borrowers in the loan pool are still making their payments each month.
The bonds that are sold via ABS transactions are structured into different seniority layers, or “tranches”, which each carry a certain risk and return profile based on their position in the capital structure.
A sample RMBS structure
For illustrative purposes to demonstrate the typical structure and not based on a particular security. Source: TwentyFour
Much like the illustration above, the highest ranked bonds (and thus lowest risk) are typically triple-A rated and pay the lowest yield but they are first in line to receive interest and principal payments from the asset pool, which flow like a waterfall down the layers.
These AAA notes are further protected by their seniority in the structure. The lowest rated tranche at the bottom is the first to absorb any losses caused by defaults on loans in the pool. Importantly, only defaults where a resulting loss occurs create an impact on the ABS deal. Loans often come with collateral like a residential home, car, commercial property or recourse to the borrower’s other assets, so a default doesn’t necessarily mean a loss for the lender.
However, structural features built into ABS to protect investors, such as a cash reserve fund that sits below the entire bond stack to help cushion against losses, make this extremely rare, particularly in European ABS.
The video below runs through how these features work in practice for a typical RMBS transaction but the same would generally apply regardless of asset pool.
Yield – ABS normally offer a higher yield for a given rating or maturity than more mainstream investments such as government or corporate bonds. This is partly due to the product’s perceived complexity and more comprehensive underwriting process – it also remains a largely under-researched and poorly understood market in our opinion and we think this adds to the associated complexity premium.
Inflation protection – ABS in Europe are virtually all floating rate, with near-zero interest rate risk. This means they're expected to be far less volatile than fixed rate bonds when inflation is high or in periods when interest rates are rising.
Diversification – ABS offers direct exposure to consumer credit risk, which is useful for those looking to diversify a bond portfolio away from more common government and corporate risk; history indicates that ABS have an extremely low, or even negative, correlation to the performance of traditional asset classes.
Flexibility – ABS has something for every risk appetite. It is probably the most flexible part of the fixed income universe, with opportunities to invest across the full spectrum of ratings from triple-A to single-B and even unrated.
Investor protection – ABS transactions are structured into layers of risk, with the issuer taking on any initial losses and the junior tranches acting as loss absorbers to the more senior ones. The assets sit in a legal entity fully separated from the issuer of the ABS, thereby protecting them from outside events such as a lender's failure.
Low defaults – ABS has historically demonstrated a very low default rate through several economic cycles. This is a result of the typical asset quality backing deals, the aforementioned protections for bondholders, as well as the fact that that this protection typically builds over time as the underlying loans pay down, with tranche more likely to experience upgrades than other bond markets.
Transparency – Issuers provide frequent reporting detailed enough to view the performance of each individual loan in the asset pool, enabling investors to forecast, stress test and have confidence in their performance.
ABS is often cited as the chief culprit in the financial crisis of 2008, and while certain parts of the market were certainly at the centre of the fallout, we believe there are fundamental misconceptions about its role that persist to this day.
Essentially, the crisis began with weak lending standards in the US allowing some poor quality loans to be packaged into ABS products (US ABS). The prime example was mortgages given to “sub-prime” borrowers who were less likely to be able to keep up repayments through the following recession. When borrowers began to default on these loans in large numbers in 2007 and 2008 – as US house price growth began to slow – the lowest tranches of US ABS transactions backed by these mortgages began to suffer losses and their value dropped.
It was a range of other flaws in the financial system – mostly unrelated to ABS – that turned this localised US housing market slowdown into a global liquidity crisis and economic recession. Loose regulation had allowed financial firms to take on large amounts of leverage and develop a string of complex derivatives products in the early 2000s. The opacity of this system exacerbated the crisis as major global banks began to worry about their rivals’ exposure to the sub-prime market, and stopped lending to one another.
The biggest misconception, however, is that the European and US versions of ABS are the same thing. They may share the same acronym, but there are fundamental differences between the two that enabled European ABS to actually perform as expected through the financial crisis.
Realised losses on the $5.2 trillion of US structured finance1 transactions issued between 2000 and 2008 and rated by Fitch were $195 billion, or 3.8%. Realised losses on the €2.18 trillion of European structured finance transactions issued in that period were just €8.2 billion, or 0.38%.2
Losses in the US market were ten times those in Europe. In addition, every year since 2009 realised losses in Europe have been zero, and Fitch’s expected lifetime loss rate for every European ABS issued since 2009 is also 0.0%.
There are three main features of European ABS that we believe make it more investor friendly than its US counterpart:
1‘Structured finance’ includes ABS, CMBS, RMBS and structured credit
2Fitch Ratings ‘Structured Finance Losses - Global 2000-2016 Issuance’ (Jul 2017), TwentyFour
