AT1 contingent convertible bonds (CoCos) were in the news in the first quarter of this year following the takeover of Credit Suisse by UBS. Atlanti’s Head of Research Romain Miginiac says that despite this, the AT1 market remains viable and attractive within the subordinated debt of European financials.
The full write-down of Credit Suisse’s (CS) AT1 CoCos imposed by the Swiss regulator FINMA has cast a shadow over the future of the asset class. A potential lack of demand for AT1s, significantly higher risk premia required by investors and an inability for banks to access the market were among the myriad of arguments floated following what has been the most significant event for the AT1 market to date. While elevated volatility may persist as the dust settles, over the medium to long term, permanent damage is unlikely, in our view, as nothing has really changed for AT1 CoCo holders in European and UK banks.
The CS story is not a game changer for the AT1 market
Beyond CS, the end of the AT1 market has been called in the past, whether following the bail-in of Banco Popular’s AT1 CoCos in 2017 or the first non-call of an AT1 by Banco Santander in 2019. These are now mostly remembered as non-events, and the asset class marched on. The write-down of CS’s AT1 CoCos is without doubt the single largest event to hit the market. However, we do not think it is a game changer.
CS was around 8% of the European banks AT1 CoCo market in early 2023, with USD 17 billion of bonds outstanding (nominal value1). While this is a hit for the market, longer-term loss rates on the AT1 CoCo market remain low. CS and Banco Popular have been the only two loss events over the decade in which the AT1 market has been in existence, and annualised loss rates over 10 years on AT1s are around 1% per annum, which still compares favourably to circa 2.5% annualised loss2 rates on global high yield. We believe investors are willing to invest in high yield with lower yields than on AT1 CoCos, as well as higher loss rates – hence the attractive case for the asset class does not seem derailed. Moreover, EU and UK regulators were quick to reassure investors that creditor hierarchy will be respected (AT1s being senior to equity) and reaffirmed AT1s being a core part of banks’ capital structure. Highly dislocated markets could lead to prohibitive issuance costs in the near term, but it is unlikely to jeopardise the viability of the asset class.
Valuations on AT1 CoCos from European banks are currently fully dislocated, with double digit yields and spreads close to the 90th percentile. At 10.7% average yield and circa 550 bps of spread, the asset class screens extremely attractive. Historically, when spreads have been this wide, total returns over the next 12 months have been strong, often double digit. On top of high income captured, we believe two catalysts on the horizon should be a tailwind for the asset class. Looking ahead, the first obvious catalyst – an immediate one – is the upcoming publication of bank earnings for the first quarter 2023 as a reminder of their robust fundamentals. Interestingly, the most likely and best-case outcome for bondholders would be the status quo – a reminder that: (1) banks continue to benefit from higher rates through earnings; (2) capitalisation and asset quality remains strong and; (3) specific concerns around liquidity and deposit flows are unfounded for large European banks. Second, the majority of AT1s are still likely to get called on their first call date. Experience has shown that non-calls have been the exception so far, and more than 90% of AT1 CoCos have been called at their first call date since the inception of the market. While calling an AT1 CoCo and refinancing at a higher cost may seem counterintuitive, European banks tend to have a long-term approach to making call decisions.
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2Source: Moody’s, as of 31 December 2022.
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