In 2013, as BBVA prepared to sell the first additional tier one (AT1) bond to be compliant with Europe’s capital requirements regulation (CRR), market participants were a little sceptical about the potential depth of demand for the new asset class.
A number of important investors were distancing themselves from AT1, which represented a new level of risk and complexity for traditional buyers of bank debt instruments — the asset class is meant to be the first line of defence after common equity in the event that a financial institution fails, and coupon payments are entirely discretionary.
Nobody was quite sure the market was deep enough to absorb the €300bn of AT1 supply over the coming the years that some were predicting, and people were even less sure about how much investors would require as compensation for the risks they were taking on.
When the deal came, BBVA paid a coupon of 9% for its new $1.5bn perpetual non-call 2018, and attracted some $10bn in orders. Although there have been some bumps along the way over the last four years, the market has hardly looked back.
Some of the biggest players in fixed income investment have set up specialist funds to buy contingent convertible capital instruments (CoCos) like AT1s — including Algebris, Bluebay, Pimco and Pioneer — as a professional investor base has developed around the product. In the past year many of those funds have been performing extremely well, averaging returns of 7%-8% and attracting more and more investment.
Unfortunately for investors, however, the AT1 market has already fulfilled a lot of its potential growth in terms of volume.
“We are seeing a big build-up in the institutional investor base for AT1 at a time when the supply calendar looks very light,” says Barry Donlon, global head of capital and liquidity solutions at UBS in London.
According to figures from the independent research provider CreditSights, 55 European banks have issued 134 AT1s worth a total of about €112.35bn.
Estimates from bankers suggest there could be at most another €100bn of new supply over the next few years, as banks build towards having 1.5%-2% of their risk-weighted assets in AT1 and as a number of new faces grace the market for the first time.
Clarity is security
Next year eyes will be focused on those bonds that are up for calls, rather than net new supply.
BBVA’s $1.5bn 9% AT1 is the first instrument to face a call date in May, and plenty of other banks will have to decide whether or not they want to extend the lives of their bonds or refinance them in the capital markets.
Previously there has been an unwritten agreement that issuers would exercise calls on their bonds as a way of doing good by their investors, but those assumptions have been rocked in the past few years.
Indeed, Basel rules for new-style AT1 instruments insist that “there is no maturity date and there are no step-ups or other incentives to redeem” — factors that are already implicated in the way AT1s are priced. Standard Chartered helped erode the principle that bonds must be called when, last November, it said it would not redeem its $750m 6.409% legacy tier one deal.
“One function of moving to a specialist investor base is that it can help everybody understand that borrowers will have to act economically when looking at calling AT1s,” says UBS’s Donlon. “That development is very positive, and it makes for a much fairer and more transparent market for issuers and investors.”
Indeed, if it is clear that banks will only call their old bonds when they can issue a new deal more cheaply in the primary market, then it follows that investors can focus on other risks inherent in the AT1 asset class.
The main point of consideration over the past year has centred on the probability that an issuer has to stop making coupon payments.
There have been a few near misses in this regard. Most recently, market participants have been keeping close watch on Banco Popular’s capital cushion above the maximum distributable amount (MDA) — the point at which banks face restrictions on making payments on bonds and equity.
But regulators seem to be on the side of investors, as they have shown signs of favouring a stable secondary market for AT1 instruments rather than a more volatile one.
Not only has the European Commission given explicit preference to AT1 coupons over dividend payments and bonus accruals, the European Central Bank has also split its Pillar 2 capital demands into a binding requirement and non-binding guidance, automatically giving issuers larger MDA buffers.
“Some of the regulatory actions around AT1 have helped the market considerably, but there is still work to be done,” says Kapil Damani, head of capital products at BNP Paribas in London. “When a bank is in breach of the MDA it is effectively allowed to pay out a proportion of its most recent net profits. However, it would be helpful to have a longer look-back period, for example one that looks at annual profits or profit over some other time period. Further work in clarifying how the MDA works would be very helpful for AT1 investors.”
With such a strong regulatory backdrop, and with supply forecasts shrinking, AT1s have recently enjoyed a spectacular performance in the secondary market. Over the past four months, the asset class has rallied by more than five cash points across the board.
“Not only has the AT1 market matured,” says Sandeep Agarwal, co-head of the capital market solutions group and head of EMEA DCM at Credit Suisse in London. “But bank fundamentals have improved to support a more stable trading behaviour.”
Many market participants also think the asset class is less prone to sector-wide sell-offs.
Since February 2016 — when prices plummeted as much as 10 cash points because of confusion around banks’ capital stacks — the investor base for AT1 has become more sophisticated, and there has been much more clarity about how the product will work to absorb losses in the event a bank fails.
“The early AT1 market was more of a yield-driven play, and there was less credit differentiation between issuers,” says BNP Paribas’ Damani.
“Transactions were therefore being priced at relatively similar levels to one another. But the AT1 market has matured considerably in the last few years. Investors are now distinguishing between weaker and stronger banks, and that is a step in the right direction.”
With the asset class trading in a stable fashion, and with yields on many securities reaching levels that have never been seen before, it would be reasonable to think that demand from investors might start cooling off.
But FIG bankers are confident that the rally in AT1 still has some way to go.
There has been an obvious imbalance in the market in 2017, as hundreds of investors have queued up to buy quite a small selection of new transactions.
“AT1 at 5% looks expensive to some investors, but it is only expensive on a relative basis versus historic comparisons,” says UBS’s Donlon.
“Compare AT1 levels with corporate hybrids or the high yield market and it looks good value. It is only if you compare AT1 with itself a year or two ago that it looks expensive.”
Issuers with calls coming up should therefore be confident that they will be able to refinance their bonds at much cheaper levels.