European AT1s: don’t miss the trees for the woods
The thinking that the additional tier one (AT1) market should go back to trading through its pre-pandemic valuations holds big risks.
The market has recently become much more enthusiastic about AT1 deals — the riskiest part of the debt capital structure for banks.
Spreads in the asset class in euros have halved in the last year, climbing down from a peak of about 700bp at the height of the coronavirus crisis.
Analysts are confident the rally has further to go, with spreads still 100bp wide of where they were in the run-up to the pandemic.
There are certainly plenty of reasons to be cheerful about the outlook for valuations.
European lenders were able to pull through 2020’s economic turmoil without suffering much damage to their capital positions, meaning that subordinated bondholders remain well protected.
The opportunities also look good in relative terms. AT1s have plenty of catching up to do before they get anywhere near their risky, high yield counterparts in the corporate bond market, for example.
Throw in a massive expansion of quantitative easing programmes and it’s easy to see why investors think AT1 spreads should soon be able to get back to their pre-pandemic lows — as many other asset classes have already done.
But despite all of the enthusiasm around the overall AT1 market, investors must stay mindful of the problems that could be lurking within individual bonds.
On the whole, the banking sector has held up well during the pandemic, but there are major red flags within some parts of the industry.
In December, ECB supervisor Elizabeth McCaul warned that institutions were following very different approaches in their loan loss provisioning. Some of them had been happy to adopt a wait-and-see attitude, she said, while others strayed away from the official macroeconomic forecasts.
“If banks do not strive now to understand and accurately reflect creditworthiness in their portfolios, they will pay the price later on,” McCaul cautioned. “Possibly a higher one.”
Therefore, it’s reasonable to assume that some banks will run into difficulties with their asset quality once government support measures end.
This has always been a major challenge for AT1 investors. Despite some episodes of mass panic, the real problems are likely to stem from individual issuers — be that coupon or principal losses or missed call dates.
At the moment, some of the risks may be captured by the premiums on offer in different parts of the market, but outperformance in AT1s will depend on more compression within the asset class, with any extra yield being treated as valuable.
That means that lower rated banks will have to close the gap on their higher rated peers, while bonds with longer call periods will have to trade in towards instruments with shorter call dates.
So if investors want to keep riding the AT1 rally, they may need to start taking on much more credit risk.
Past performance suggests that the rewards may be worth it, b ut it is also worth remembering that not every bank will come out of the coronavirus pandemic in as healthy a position as they went into it.