Co-Co’s are Go, Go, Going Away? The Rationale for Cooling on AT1s

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Introduction

In recent months, AT1s have been back in the press again, with news, first reported by Bloomberg, that the Dutch authorities had proposed abolishing these post-global financial crisis deeply subordinated debt securities.[1]  

Since declining aggressively immediately following Credit Suisse's collapse and the unexpected write-down of the beleaguered Swiss bank’s AT1s ahead of common equity shareholders, the junior financials debt asset class has staged a forceful comeback.

Since its nadir in the Spring of 2023, the iBoxx Contingent Convertible Liquid Developed Index EUR is up 37% (see below).

Exhibit 1: iBoxx Contingent Convertible Liquid Developed Index EUR, 5-year performance

_{(Source: LSEG/Refinitiv)}

With the benefit of hindsight, we can identify the roots of such strong performance in factors including:

• Record level of bank capital,
• Central bank interest rates at post-GFC peaks across Europe and the US, and
• Unemployment remaining low and stable.

Such dynamics have also lent support to bank share prices.

For AT1s in particular, an additional tailwind has come in the form of national financial regulators in the wake of the Swiss authorities' breach with capital structure orthodoxy, reiterating the conventional priority of payments in a bank resolution scenario.

We’ve also seen a recovery in the market for new AT1 issuance.

How investors view the market today

In conversations with investors in recent months, the prevailing mood for the asset class has been optimism and a greater sense of resilience following a series of real-life stress tests in recent years, starting with the pandemic, followed by the Ukraine conflict, the collapse of SVB and Credit Suisse, and most recently, the resurgence of the conflict in the Middle East.

We think such optimism should be accompanied by a word of caution.

Today, the AT1s of the largest seventy-five AT1 issuers in Europe have an average running yield of 7.1% with a cash price of 97.[2] In the context of our generic risk-free proxy, 3-month Euribor, just under 4%, we superficially find this spread relatively unappealing.

We also note some pockets of potential frothiness:

Earlier this year, RBI moved close to issuing EUR650m in notes of the junior security at an 8.5% yield. In the context of the bank’s ongoing management of its Russian exposure and therefore sensitivity to difficult-to-quantify geopolitical risk, we find this pricing somewhat stretched.

Elsewhere, Nationwide’s PIBS pay a running yield of 6.3%, versus a UK-government (redeemable) 10-year paying around 4.5% and, for the individual investor, deposit-protected and therefore risk-free fixed-term bonds still above 5%.

The PIBS of OneSavings Bank PLC, meanwhile, have a running yield of 4.6%.

Taking a step back – The FFL portfolio

All of this points to pockets of frothiness in the market that we believe should give investors reason to pause.

Above all, though, we are cool on the sector given the opportunities we see presently to pick up both more structurally senior instruments for equivalent yields and similar risk.

Notably, insofar as said instruments – unlike AT1s or PIBS – have mandatory redemption features, they have an embedded catalysts which, in our view improves their relative attractiveness.

Within the FFL financials portfolio today, we have active investment recommendations in one high yield bond and two zero dividend preference shares that we think investors will find attractive.

Combined, these instruments have an average yield-to-maturity of 11%, an average loan-to-value of 30% (i.e. the securities are >3x covered by tangible assets) and an average maturity of 2 years.

Importantly, none of these securities have material debt above them in their respective capital structures, making them - in our view - de-facto senior credit risk.

In the context of UK risk-free at c.4.5% and inflation below 3%, we think these return profiles are compelling. Crucially, we think they compare favourably to the equivalent risk-adjusted returns offered by the majority of AT1s available in the market today.

Conclusion

Ultimately, we view AT1s as a positive financial innovation that have an important place in banks' capital structures. At the same time, we think the current environment provides a good point to take stock and review the attractiveness of the asset class in the context of the broader financials fixed-income opportunity set.

For clients of Fighting Financials, click here to access our long financials credits recommendations, as well as our broader portfolio of long equity ideas and short ideas – equity and credit.

For prospective clients, both individuals and institutions, interested in learning more about the Fighting Financials investment research service, please click here or reach out at info@fightingfinancials.com for an initial, no-obligation discussion.

Until then,

Your FFL Team

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[1] See “Netherlands Floats Ending AT1s After Credit Suisse Upheaval”, Bloomberg article, 20^th March 2024

[2] Fighting Financials calculations, aggregating LSEG/Refinitiv data