AT1: When they go low, you go high

It has not been a good few weeks for the CoCo bond. In late April, The Economist newspaper declared that, nine years after the first bonds were issued, they have not fulfilled their promise.

“The idea that CoCos would help struggling banks recapitalize seems far-fetched,” they say, describing them as a niche investment. “This is quite a comedown for an asset class once touted as an elegant, almost automatic way to return struggling banks to health.”

That might be a little unfair, but in its monthly report for March 2018, the Bundesbank revealed itself as not the biggest fan of the CoCo bond either. One fairly fundamental problem, it states, is that the 5.125% of RWA conversion trigger that is in place for more than 40% of European AT1 bonds outstanding is actually lower than the point at which the European Central Bank would consider the bank a gone concern.

The German central bank has, therefore, recommended an exploration into how far this threshold should be raised in order for CoCo bonds to have the effect that the regulators actually intended.

Collapse

It seems a little late for that. Many investors have long argued that the 5.125% trigger is too low – something that was spectacularly illustrated last summer with the collapse of Banco Popular.

The bank was declared non-viable due to overwhelming deposit flight when its most recent CET1 ratio was 8.2% – miles away from where the bonds should have been triggered. Its AT1 bonds were treated exactly the same as its tier-2 bonds in the subsequent resolution, which is hardly what all that financial engineering was designed to do.

The authors of the Bundesbank report question what advantages such bonds have over CET1 capital, stating that “it is unclear whether their supposed cost advantage over CET1 capital actually exists if the high complexity and associated risks are factored in”.

That the performance of tier-1 capital instruments in a crisis is somewhat unpredictable is nothing new, but try telling bank capital investors that.

The first such deal is rumoured to be circulating in the market, although banks are understandably reluctant to be the first to jump 

The Bank of America Merrill Lynch CoCo Index moved from 6.14% to around 4.40% last year and spreads have ground in from there – Nordea’s €750 million bond in November paid just 3.5%, but still attracted an order book of €5 billion.

The well-trodden argument that banks are now safer than corporates has relevance here, but what is probably more important is that after $155 billion of issuance in 2017, the AT1 machine is grinding to a halt. Citigroup forecasts just €13 billion of new euro-denominated AT1 issuance in 2018.

However, yield-starved investors are still flooding into the market. Although investors typically enjoy spreads for single-A rated bank credit that they would have to go down to double-B corporate credit for, the present demand dynamic saw AT1 trade through high yield in the last quarter of 2017. But 13 European banks have call dates for their AT1 bonds in 2019, which will see the market inch back in the buyer’s favour.

Doubts

What to do in a market where doubts are being sewn over the effectiveness of low-trigger instruments while investors are still clamouring for paper? The answer is obvious: design a new higher-trigger instrument.

This is now reportedly in the works. So far, AT1 issuers have either issued low-trigger (5.125%) or high-trigger (7%) instruments. The idea is that banks could now issue a new AT1 bond that would have an even higher trigger at about 9% or 10%. The advantage for the issuer is not necessarily for the instrument to add to its AT1 bucket for capital purposes, but to act as an additional buffer for stress-testing purposes that is cheaper than equity.

For investors, this would be an AT1 instrument with extra spread – so, effectively, Christmas. How much extra spread? Bankers that Euromoney speaks to suggest such bonds should price at less than 100 basis points more than regular AT1 – maybe just 37.5bp to 50bp more.

There would likely be a deluge of demand for the bonds from the same subordinated FIG investors that have driven the market to its present spread levels.

The first such deal is rumoured to be circulating in the market, although banks are understandably reluctant to be the first to jump. Such a deal might, however, emerge after the summer.