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Why do AT1s trade with high yields?

Publication Date: 14 Feb 2019 - By GJ Prasad By GJ Prasad
Actionable
Differentiated

Investment Strategies Fixed Income/Credit UK EU ex-UK Financial Services

Someone earlier asked me a thought provoking question on AT1 to me – why do they trade with such high yields given the coupons are almost safe (and most likely be paid) and bonds may get called on first call date and the banks issuing them are so well known domestic names?   

And I just did not know where to start and how best to put it across to that investor that the AT1 instrument is more like an equity instrument sold in a debt format and the investor has sold many options to the issuer.   Many investors have bought this instrument for its relatively high yield and debt type features and conveniently forgotten the equity type risks loaded in the same. But frankly, I think AT1 is more a hybrid instrument with significant tail risks embedded in them. 

Optional coupon deferral/ call risk
Whilst coupons will most likely get paid for most issues unless mandatory deferral clauses come into play, purely from a structure perspective, they are discretionary payments (issuer has optional discretion not to pay) and are non-cumulative in nature.  As far as the call is concerned, it is entirely an economic decision based on where the bank can re-issue / refinance the same and to that extent irrespective of the reset spread, it is entirely possible that issuer decides not to call as market conditions are not favorable.  And yes the higher reset spread on older AT1s may yet prove to be decisive in the economic decision to call.  However, the issuer may yet decide not to call the bonds and then subsequently suspend the coupon.  

Will any of the current European banks dare do that anything like that?  The answer is most likely a big “no” as it will cut the issuer from future sub-debt issuance for an extended period of time.  

Can it happen at all?
But, consider this scenario in the next 12 months – issuer has already filled the AT1 quota, has a decent CET1 ratio (and is well in excess of requirements), is in a deleveraging mode, has plenty of funding options (and hence MREL/TLAC* may not be an issue) but has very poor profitability due to business model, equity shareholders have taken a bucket load of pain and equity dividends are likely to be skipped and the issuer has to incur significant restructuring charges in one go to simplify the set up.   Finally, the share price trades a huge discount to tangible discount value and market perception on the issuer about its turnaround prospects are poor.

In such a scenario, I believe that the issuer may yet consider the optional coupon suspension for the AT1 instruments to further preserve capital and/or appease some shareholders (who may not be getting any dividends).   And that is perfectly allowed by the terms and conditions of the instrument.  I would assign a very small probability to that event but if it were to happen, it may turn out to be a giant one for the asset class.  

And as far as the call is concerned, good luck to those investors hoping that issuers will make non-economic decisions.

Conclusion
AT1 – is this sub debt with equity features or equity like instrument with loaded options?  Or just an awkward one that satisfies no one...and hence I keep repeating the same thing – AT1 needs expert/specialist handling and an extreme form of “buyer be aware”.   Having said that, keeping the negative generalization of the asset class to one side, there are enough upside opportunities in this space if (and that is a big if) proper single name selection and within that a deep dive issue level analysis is carried out.

 

* MREL: minimum requirement for own funds and eligible liabilities; TLAC: total loss-absorbing capacity

Disclosure:

I have no positions in any of the securities referenced in the contribution

I do not use any non-public, material information in this contribution

To the best of my knowledge, the views expressed in this contribution comply with UK law

I agree with the terms and conditions of ReachX

This contribution is for informational purpose and does not constitute investment advice nor is it an offer to sell or buy, nor is it a recommendation for any security.

GJ Prasad

 

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