Following the Great Financial Crisis of 2008/09, regulations such as Basel III were introduced to strengthen bank balance sheets and make the sector more resilient to exogenous shocks. An example of the effectiveness of these reforms is the much improved capital positions of European banks. The entire banking sector, and in particular systemic banks, hold significantly more capital today with Tier 1 Equity Ratios, a key measure of the strength of a bank’s balance sheet, at c. 13% for larger European financial institutions, more than double the level they were pre-2008. Similarly, recently enacted regulatory and governmental relief measures following the outbreak of Covid-19 should also act as a shock absorber for banks with reductions of countercyclical buffers, less stringent assessment of provisions and cancellation of equity dividend payments all helping to keep balance sheets strong and weather potential future storms.
Each of the steps taken to ringfence the banking system are positive for AT1s and keep the three risks specifically related to the asset class in check. Coupon Risk is the ability for AT1s to suspend coupons in times of acute stress. Although the ECB has recommended suspension of equity dividends until January 2021, this does not apply to AT1 coupons and the financial regulator has been clear in this regard. Retention of capital on a bank’s balance sheet instead of distributions to equity investors further strengthens the financial institution and is a clear positive for debt investors. AT1s are perpetual instruments with callability at set intervals.
As such, AT1s have Extension Risk in that the bonds may not be called by the issuer. Year-to-date, in spite of the significantly elevated market volatility, the vast majority of AT1s have been called. The two issuers that did not call their AT1 bonds had idiosyncratic reasons for doing so with neither having any adverse impact on the market. Finally, AT1s have what is labelled Trigger Risk. If the capital levels of a bank drop below a predefined level, the AT1 can become equity or be written down (permanently or temporarily). However, as discussed previously, banks are much better capitalised today than historically and we would expect that even in Lehman-like loss scenarios, large European banks would not see their AT1s fall below the respective trigger levels.
Beyond this favourable fundamental backdrop, AT1 spreads are close to their average levels since inception in 2013 and significantly above pre-Covid levels. Consequently, in a stabilisation scenario, the income level is attractive and should the spread tightening trend continue and yields fall to pre-Covid levels, the potential for capital gains (on top of income gains) from investing in AT1s is significant.
Christel Rendu de Lint
Head of Fixed Income
Bernard McGrath
Senior Fixed Income Investment Specialist