The primary market for European bank additional tier-1 (AT1) bonds reopened in June after a closure of nearly three months. This followed the wipe-out of $17 billion worth of Credit Suisse bonds on the grounds that the Swiss bank would not have been viable without the state support UBS negotiated as a condition of its rescue takeover.
In the immediate aftermath of that shock, some European bank AT1s were quoted in the low 60 cents on the euro, although traders say they could not buy much at that price. The index average fell to 85c.
The subsequent recovery in secondary market prices was swift, with the leading banks heading back up to the high 90s, before BBVA launched a €1 billion, non-call five-and-a-half, contingent convertible that came at an indicated coupon of 8.75%.
That was well below the 10% coupon that some bankers feared might be necessary to revive the market and, having attracted €3.1 billion of demand, the issuer priced at just 8.375%.
With economies on the cusp of a downturn that will increase bank non-performing loans, now would seem a good time to address the sustainability of AT1s
Don’t believe that the AT1 market is fixed, however. The test is not a reopening deal in calm market conditions by the national champion bank that launched the first-ever such deal 10 years ago.
AT1s became a vital market in which banks raised close to $300 billion of capital in a decade of low growth, negative rates and single-digit – often low single-digit – returns on equity. They could never have raised so much straight equity.
The real test will come in the next system-wide or bank-specific stress, when it remains to be seen whether investors, fearing a similarly messy resolution for the next large bank to hit trouble, flee AT1s and prompt a spillover panic in holders of bank equity and bank deposits.
It would be smart to learn now from the March crisis and perhaps adjust AT1s to preserve the structure of a sizeable capital market on which banks still depend.
The European Banking Authority has been sounding issuers and investors out for possible solutions and one that keeps coming up would be to make coupons on AT1s cumulative. In other words, banks might skip them to stem payouts in a period of stress but then pay them in full if and when they recover.
Bank regulators initially made AT1 coupons non-cumulative – they can be skipped but not then made up – so that the instrument more resembles pure equity. But the Covid crisis set the precedent of regulators pressing banks to suspend dividends, which strong banks simply set aside to pay out when that ban was lifted.
Jerry del Missier, chief investment officer at Copper Street Capital, which invests across the bank capital structure, and a former co-chief executive of Barclays corporate and investment bank, advocates a similar approach to AT1 coupons. He points out that for an investor, if a bank skips a coupon today, that money is lost forever. That creates a cliff edge. This is not a time to line banks up along one.
It wasn’t as if Credit Suisse had a toxic balance sheet. In fact, it had many strong businesses. But if it had skipped a coupon to preserve some liquidity amid deposit withdrawals, that would only have exacerbated the panic.
With economies on the cusp of a downturn that will increase bank non-performing loans, now would seem a good time to address the sustainability of AT1s.
If a whole market can fall 15 points on contained problems at just one bank, that is not healthy.