After the dust settles in the AT1 market

After the dust settles in the AT1 market

In the past decade or so the additional tier one (AT1) market has experienced occasional semi-cathartic events that naysayers jumped on to pronounce that the market is dead. Of course, this was never true, just as it isn’t true this time. It usually ends the same way – with some unfortunate casualties, but also plenty of opportunities.


The history

AT1 debt is basically designed to soak-up bank losses and can convert into equity or be written down to zero, if regulatory capital falls below a certain threshold or the institution is no longer deemed to be viable. We feel like veterans of the AT1 market already, having witnessed the European market from its very beginning in 2013, when Banco Bilbavo Vizcaya Argentaria (BBVA) issued the first ever contingent convertible (‘CoCo’) bond, with a 9% coupon and whopping four different write-down / conversion triggers.


First it was Banco Popular’s demise in 2017 and the writing-off of their AT1 instruments to zero, which preceded its acquisition by Banco Santander. This was the first ever ‘zeroing’ of an AT1. An unprecedented event that was surely supposed to ‘serve as a wake-up call’ to investors and ‘permanently increase the cost of funding’ for banks. Within a week the market had moved on.


In 2019 Banco Santander became the first European bank to break with the convention that AT1s are called on their first call date, irrespective of economics. They skipped the first call date on their bond, because…. it was cheaper to do so! Scaremongers claimed this would break the AT1 market, force a fundamental re-assessment of the securities, and ‘permanently increase the cost of capital’ for banks. Within a week the market had moved on, albeit with increased focus on the AT1s’ reset spreads.


Fast forward to 2023 and we have a relatively streamlined AT1 structure (albeit still far from perfect) with broadly uniform terms and conditions around triggers, conversion mechanisms and interest deferral.


Last Sunday, Credit Suisse was taken over by UBS and its stack of AT1 bonds were also written down to zero. The story repeats, with suggestions that this will ‘permanently increase the cost of capital’, ‘force some investors out of this market forever’, and so on. Once again, we expect the market to move on.


The bigger picture

Credit Suisse has faced a number of scandals and issues over the last few years, highlighting in particular governance and risk management deficiencies. The recently announced strategic review aimed to remedy this, as well as downsize the (loss-making) investment banking activities. It was feasible to envision a successful transformation of Credit Suisse, as demonstrated by other institutions in the past (such as Deutsche Bank, among others). Through a combination of restructurings, retrenchments, and a focus on core businesses, these institutions have pulled through, resulting in solid risk adjusted returns for patient investors. However, in the case of Credit Suisse, the prior challenges and negative sentiment, combined with the swift decline in market confidence, ultimately led to a rapid unraveling of a large systematically important financial institution.   


We believe that the end outcome – with UBS absorbing its Swiss rival with no losses borne by senior holding company creditors, is positive from a financial stability perspective. The fact that CS’ AT1s instruments were written down to zero should not in itself be seen as an extreme development, due to the nature and construct of the instruments. However, the fact that there was some residual value in the bank’s equity rather than in its AT1 bonds has taken centre stage, questioning the creditor hierarchy principles embedded in financial markets.


The legal bit

The Swiss regulatory regime that covers, amongst other things, the treatment of AT1s in a bank’s capital stack, was always somewhat different to the rest of the EU (and the UK). In particular, the terms and conditions of AT1 instruments specified that "Notes could be cancelled in whole or in part prior to the cancellation of any or all of CSG's equity capital".


In simple terms, in specific circumstances, Credit Suisse AT1s could be (and were) zeroed before any loss on the firm’s equity was imposed. This is materially different to how regulators in the rest of the European Union and the UK (which essentially is the rest of the AT1 market) would treat AT1s at the point of resolution, as confirmed by both the ECB (in conjunction with the SRB and EBA) and BoE on 20 March: “AT1 instruments rank ahead of CET1 and behind T2 in the hierarchy. Holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy.” (Bank of England)


The moral of the story

The Credit Suisse debacle has reminded investors about the power of declining market confidence. Although Credit Suisse was a solvent company with a solid capital base and on the path toward reinventing itself, the extremely negative market sentiment led to significant client outflows, which rapidly became self-fulfilling and created material liquidity challenges. 


In this situation, the UBS deal ultimately proved to be good for most bondholders, as all bonds except AT1 securities have rallied since then.


Although markets have been quick to raise concerns about the overall AT1 market, it is critical to remember the differences in AT1s across jurisdictions. Swiss AT1s will continue to be inherently riskier than EU or UK issued AT1s. We suspect that going forward this risk might be better reflected in their price, but markets have a short memory. Time will tell.


For the rest of the AT1 market beyond Switzerland, the simple story is that this changes little.


Along the way, some market participants are reminded that one of the defining characteristics of these securities is to be written down or converted to equity in times of stress (it is even reflected in the name, ‘Contingent Convertible Bonds’).


Ultimately, we do not believe recent events will materially and permanently increase the cost of capital for banks, neither do we anticipate that AT1s will no longer have an important role in the capital structures of EU and UK banks.


The opportunity

After several days of mayhem, we are left with an AT1 market that offers real opportunities. No AT1 currently trades above its issue price (usually par), with a large number of bonds also pricing extension to perpetuity.


We believe this is wrong, which offers a number of alpha-generating opportunities. It is unusual for the market to imply so much extension (bond to never be redeemed) risk, and we believe that, on the rare occasions when this happens, it is important to look at the opposing view. The three immediate catalysts we expected to see that will help this repricing are:


  1. A statement of support by the ECB (check)
  2. A tender of senior unsecured bonds by some European bank in a show of strength that will reduce funding costs (check); and
  3. The next time an AT1 bond reaches its first call date, it will be called. Ignoring a small German lender, we are looking at June 2023 for this at the latest.


At the time of writing two of the three catalysts have materialized, although it is the third that would be the most powerful.

Important Disclosures

More about the authors

Alexander Pelteshki, CFA Portfolio Manager

Alexander Pelteshki, portfolio manager, is a member of the multi-sector portfolio management team.

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