Additional Tier One (AT1) debt suffered in the wake of the Credit Suisse wipeout last year, which saw $17bn bonds wiped out and led investors to question the credibility of the asset.
AT1s were again in the news in September, when the Australian Prudential Regulation Authority (APRA) announced plans to phase out AT1 bonds from the market earlier this month, citing concerns over the suitability of the vehicle following the Credit Suisse wipeout in March 2023.
However, products tracking the AT1 market have performed well year to date, with the WisdomTree AT1 CoCo Bond UCITS ETF – which tracks convertible bonds backed by developed European financial institutions – returning 10.26% so far this year.
The first week of September also saw a record €7.1bn ($7.8bn) issuance of AT1 debt. 18 months on from the Credit Suisse wipeout, is the asset class quietly enjoying a strong bill of health?
Australia ditches AT1s
AT1s, or contingent convertible bonds (CoCos), were introduced in 2013 following the global financial crisis as part of a move to strengthen bank balance sheets. If bank equity falls below a certain level, AT1s can be called in to avoid the need for bailouts from taxpayers as seen in 2008.
While CoCos should rank ahead of equity in the capital structure in the event of a bank failure, Credit Suisse did not technically fail and rules within the Swiss system allowed the regulator to overturn the capital hierarchy in order to proceed with UBS’s emergency takeover of its competitor in March 2023.
APRA chair, John Lonsdale, said the decision to remove the asset class from the Australian market was taken after assessing the fallout of the Credit Suisse wipeout.
He said: “The purpose of AT1 is to stabilise a bank so that it can continue to operate as a going concern during a period of stress and support resolution with the capital that is needed to prevent a disorderly failure.
“Unfortunately, international experience has shown that AT1 does not fulfil this function in a crisis situation due to the complexity of using it, the potential for legal challenges and the risk of causing contagion.”
Unlike other markets, the risks are heightened in Australia due to the unusually high proportion of AT1 debt held by retail investors, whereas European and US AT1s are almost entirely held by institutional investors.
For this reason, Gaël Fichan, head of fixed income and senior portfolio manager at Syz Group, says the decision to phase out the asset class is unlikely to be taken by other regulators.
“APRA’s move seems driven by the perceived complexity and risks associated with AT1 bonds during periods of financial stress, as highlighted by the Credit Suisse incident,” he says.
“However, we believe the likelihood of this decision leading to similar regulatory shifts in other regions is low. Europe’s banking system is far more diverse and competitive, with AT1 bonds playing a key role in optimising bank capital structures.
“European and UK regulators have been clear that AT1 bonds remain a critical component of regulatory capital, with a firm hierarchy that protects AT1 bondholders over equity holders. While APRA’s decision may spark global discussions, we do not foresee it leading to the widespread elimination of AT1s outside of Australia.”
Allie Quine, portfolio specialist, preferred securities at Cohen & Steers, agrees, adding that while the debate over AT1’s fit-for-purpose is ongoing in other countries, it is more likely that the structure is tweaked or simply left alone rather than completely eliminated given the wide acceptance from issuers, investors, and regulators.
Has the asset class moved on from Credit Suisse?
The immediate impact of the Credit Suisse wipeout saw the Bloomberg CoCo index fall 14.8% between the start of 2023 and 20 March.
“The Credit Suisse wipeout certainly sent shockwaves through the AT1 bond market, as it was the first time bondholders were completely wiped out while equity holders retained some value,” Syz Group’s Fichan says. “This breach of the established creditor hierarchy understandably caused significant panic and triggered a sharp sell-off in AT1 bonds globally. However, we view the Credit Suisse event as an isolated occurrence, specific to the Swiss regulatory and legal frameworks.
“Since then, the market has shown resilience. European regulators were quick to reassure investors that such a breach of the creditor hierarchy would not happen in their jurisdictions, which helped stabilise the market and restore confidence. In the long term, we believe the Credit Suisse wipeout will be remembered as a regulatory anomaly rather than a precedent for future events in the AT1 space.”
He adds that, despite the Credit Suisse incident, the fundamentals supporting the AT1 market remain intact.
“These instruments continue to play a crucial role in bank capital structures, particularly for global systemically important banks seeking to manage their capital efficiently. European regulators have reiterated the importance of AT1 bonds and have maintained the creditor hierarchy, ensuring that AT1 holders are protected in the event of financial distress.
“In terms of performance, the AT1 market has shown resilience, with strong returns despite recent volatility. The upcoming call dates in 2024/2025 will be a key test, but we believe issuers have strong incentives to maintain favourable relationships with bondholders.
“As recently as September 2024, the AT1 bond market saw record issuance activity, with a weekly total of €7.1bn. In my opinion, AT1s continue to offer an attractive risk-reward profile, particularly for investors willing to navigate the complexity and volatility of the asset class.”
Cohen & Steers’ Quine adds that issuance has proved attractive to a range of investor types globally.
She says: “About one and-a-half years on from the Credit Suisse AT1 wipeout, there does not seem to be a discernible impact on the market. At present, the credit spread of various AT1 indices sits at multi-year lows and well below the average since the asset class’s inception in late 2013.
“Furthermore, during the first week of September 2024, there was a record amount of AT1s issued to the market with substantial participation from different investor types across the globe. At the margin, some investors may have exited the asset class but they have been at least partially replaced by investors that had not been involved before or in as meaningful of size.”
Positive outlook for banks
Mohammed Kazmi, chief strategist and senior portfolio manager at Union Bancaire Privée (UBP) also holds a positive view towards the asset class going forward.
“AT1 bond issuers are also helping sentiment by consistently calling their bonds, in a move that has also benefitted from how well the new supply has been digested by the market as cash on the sidelines is put back to work.
“We expect for this impressive track record of calls to continue as last year’s volatility appeared to raise the bar for banks to exhibit a strong capital position, which is notably expressed through their ability and willingness to call their AT1s. A clean call track-record also contributes to the credibility of the bank among investors.”
Kazmi says that, from a fundamental perspective, the banking sector remains a key beneficiary of a higher rates and inflation backdrop.
“On the top-line, banking revenues have expanded, helped by higher net interest income on the back of rising high rates and increased trading given higher volatility. Also, asset quality held up well with stable NPL ratios and provisions usually being lower than expected. With regards to capital, banking capital positions have remained solid.
“From a markets perspective, we believe that this backdrop is one in which investors should focus on the attractive carry opportunity that continues to present itself within the AT1 market today.
“Despite the strong performance of the asset class YTD, one is still able to benefit from yields in the high single digits, which should help buffer against bouts of volatility. At such elevated levels of yield, time in the market becomes more important than timing the market, whereby the dovish pivot from the central banks should also help cap significant spread widening moves across fixed income.”
This story first appeared on our sister publication, Portfolio Adviser.
