Bank CFOs relying on additional tier-1 capital will hope its February rout was just another bout of short-term volatility related to macro-economic worries. But the deeper worry is that it was a more thorough re-evaluation of the AT1 bond market.
The ferocity of the sell-off was shocking. In one week in early February, euro-denominated bank AT1 bonds in Bank of America Merrill Lynch’s CoCo index dropped almost 7%, notes CreditSights. The yield, for example, on an AT1 bond sold by Spain’s Banco Popular in early 2015 with a coupon of 8.25% more than doubled to 17.9%, according to S&P Global Market Intelligence.
Many took it as a fundamental shift in investors’ understanding of what these bonds are: how close they are to equity; how easily banks may be forced to suspend payments. One senior European banker says his bank has already dismissed the instrument from its planning and that the AT1 game is over.
Aside from recent worry about the impact of negative rates on profit, new restrictions earlier this year on capital distributions, either AT1 coupons or share dividends, was one harbinger of AT1 realignment. Disappointing 2015 results was another trigger, particularly Deutsche Bank’s €7 billion loss. Despite its insistence it can meet its payments, sellers focused on Deutsche Bank, including four AT1 bonds with coupons due at the end of April. Yield on its 6.25% $1.25 billion AT1 bond rose beyond 16% to the 2020 call, according to CreditSights.
As the market comes back, issue sizes will inevitably be smaller than the standard €1.5 billion-plus bonds common earlier in 2015, admits Khalid Krim, Morgan Stanley’s head of European capital solutions. The days when RBS could issue a $3.15 billion AT1 bond as it did last August may be over. New issue premia would, at least initially, also be higher; perhaps between 25bps and 30bps, he says.
Banks’ shares fell even further than their AT1 bonds – pushing more European bank stocks below book value – so the plain equity alternative could still be less inviting to banks than AT1, even at higher coupons, bankers say.
Until AT1 yields fall to at least single digits in the secondary market, however, new issuance seemed unlikely, given common estimates of sector cost of equity slightly below 10%.
“Banks will look to issue AT1 at between 5% and 6% or between 7% and 8% depending on the institution, so if prices don’t go down issuers won’t come,” says one banker. “Above 8% they will question the viability of AT1 versus equity. AT1 can help banks to cut leverage ratio, but they won’t want a high coupon instrument in the capital structure in an environment of low interest margins.”
The €40 billion of expected AT1 issuance this year could still be done, say bankers. “We're already seeing a sharp snap back in risk appetite,” says Simon McGeary, head of Citi’s European new products group. “Investors are being tempted back in.”
Krim thinks the first new AT1 deal since the sell-off could come within weeks, as soon as banks have updated disclosure for fourth-quarter results, and the ECB’s March 10 meeting is over.
Smaller inventories at investment banks, across the bond market, amplify volatility when some investors are forced to sell, Krim argues: most of the big pension fund-type investors have not exited the AT1 market. Granted, some hedge funds invested in AT1 may have run into trouble and had to honour redemptions after the violent swings in prices; there may have been some rebalancing of portfolios away from AT1 among the asset class’s big investors.
Yet hedge funds account for less than 10% of the market, bankers insist. “The investor base for AT1 has become materially deeper and broader over the past three to four years,” says Nik Dhanani, head of capital solutions, debt capital markets, at HSBC.
“We think that the investor base [in AT1] will remain stable or grow; the attractions same as before,” says Christoph Hittmair, HSBC’s head of FIG DCM, pointing to the low rates available elsewhere. “It feels like people are coming back in.”
Perhaps, after senior unsecured, tier-2 issuance would follow. “It’s a step-by-step approach,” says Krim. “Probably we’ll see a national champion bank issuing AT1 to reopen the market.” Smaller or weaker banks, however, would have to wait for longer, possibly until the fourth quarter, given stress test results due in early June, ahead of the holidays. “The concern that issuers will have with issuing just before the stress test results are announced is the signalling that the institution needs capital,” says Krim.
Anthony Smouha, credit fund manager at GAM, says his funds have a small proportion of contingent convertible bonds, including AT1 notes issued by Deutsche Bank. He says there is little evidence that ill-informed investors dominate the AT1 market. Nevertheless, a change in sentiment is clear in a recent note from GAM – it was more cautious on Cocos, and said it would limit its exposure to the best credits. That means national champions and banks with good business models, according to Smouha.
“If the bank is creating, rather than destroying, value for its shareholders, it will be profitable, it will pay dividends, and it will pay the coupons on its CoCos,” he says. “For investors that have their eyes open, it provides a nice yield.”