AT1 instruments: Is it time to buy?

Clearly it was a tough 2018 for many asset classes and within that Additional Tier 1 or 'AT1' instruments were not spared. The asset class saw its first annual loss with most of the widely followed benchmark indices down 3% to 5%. The asset class was hit hard by a number of factors - risk aversion, tail risk events and investor apathy. 

But, it seems to me that within the credit world, AT1 was hit hard more due to liquidity and momentum factors and became increasingly technical in terms of who holds it and was driven by headline risk and everything else in terms of valuation don't seem to matter? My observations on a handful of AT1s reflect that it trades in a very tight space and ignores any concept of fundamental valuation. More so on a relative valuation basis either to equity and/or LT2 or Non-Preferred Senior. 

Looking at the performance of AT1s issued by the European banks over the last 6 months, it is clear that much of the larger "underperformance" in certain names has been driven by idiosyncratic stories/themes - ISPIM and UCGIM impacted by Italian politics, BBVA by Turkey exposure, Danske Bank due to ongoing operational risk related issues and 2018 vintage issues due to re-pricing of call risk. 

A full blown CDO type balance sheet analysis on some of the banks in my universe indicate significant relative value opportunities in both directions (long equity vs short AT1 in some cases and long AT1 and short AT1 in others) but finding right notional amounts to use and the underlying liquidity to actually put it to work is evenmore challenging. Fundamentals are important for sure but it seems market technicals seem to matter equally.

Importance of single name selection

In all most of the above names, the underperformance of equity to AT1 has been even more dramatic. Two observations - RV across issuers and/or capital structure has been the only effective way to manage the portfolio risks and the importance of deep dive analysis in selecting single name exposure within the AT1 asset class.

Now comes the more difficult part – which single name exposures to own?  Without going to specific names or issues at this stage, we could yet set up criteria to come up with a shortlist of names to own:

• Business model that is easy to understand with good visibility on both earnings and asset quality fronts
• Superior risk management framework as reflected in quality and consistency of earnings and credit underwriting over the economic cycle
• Solid capitalisation both at an absolute level and relative basis especially on the leverage metric
• Low stock of NPLs and good reserve coverage and hence any big uptick in non-performing loans can still be absorbed by pre-provision income
• Self sufficient funding and very little reliance on wholesale sources especially central bank funding
• ROE that is close (or even higher) to the issuer’s COE
• AT1 yield is significantly higher than dividend yield and AT1 coupons not at risk under most severe stress scenarios

There are a number of large cap European banks that would meet most of the above criteria (if not all the criteria). I don’t want to give away those names as yet as I am sure you will find the exercise much more interesting.

Is it time?

Bye Bye - I believe we may yet see more price weakness as more investors figure out that this asset class is not for them. And if equities keep going lower, purely from a sentiment perspective, AT1s will get dragged lower. So may be it is bye bye time for some tourist investors.  

Buy time - Having said that there are a number of issues that look attractive to own for long- term investors. Next comes the question of liquidity, as to who would be the marginal buyer of these AT1s in size and what is the clearing level for that. I believe that AT1s yielding 8% (and above) on a yield to call basis and 7% to 8% on a yield to perpetuity basis should find some decent interest.   

And when it gets there, I believe specialist bank capital funds, distressed debt shops and private equity firms will want to own this but as a price taker. The asset class needs a certain type of deep pocket investor with locked in capital and one who is prepared to do the necessary deep dive work both at an issuer level and at an issue level. And be able to slice and dice the balance sheet to estimate asset recovery values and its impact on capital structure. Finally, of course have the ability to stomach the volatility as the markets price in one tail risk event to another.