INTRODUCTION
Additional Tier 1 (AT1) bonds are debt instruments issued by large European financial institutions. They are designed to act as a buffer in extreme circumstances such as a global financial crisis, with a trigger mechanism that converts into cash or ordinary shares if the issuer's capital falls below a predetermined level. It is because of this feature - and not the riskiness of the issuer as is the case with traditional high yield - that AT1s have a lower credit rating and in turn higher coupon, compared to senior debt issued by the same entity. In addition to offering the potential for higher returns compared to investment grade credit, albeit with higher risks as mentioned above, AT1s have demonstrated a lower correlation with other asset classes. And as we all know, combining assets with lower correlations can potentially increase the benefits of diversification.
At 8%, yields on AT1s more than doubled the 3.7% they offered at the end of 2021. While the main driver behind the rise in yields has been the aggressive tightening of monetary policy to tame inflation, spreads have also widened from the tight levels seen post-covid. As with other credit markets, the spreads on Additional Tier 1 (AT1) bonds have been rallying since October after widening to attractively low levels. Specifically, the rise in yields led investors to question the reliability of AT1 bonds in the way they were originally intended.
After the global financial crisis new regulations were introduced that required European banks to issue AT1s as part of their regulatory capital. This regulation also standardized the AT1 market in comparison to prior Tier 1 capital, by establishing specific characteristics in their design. In addition to a defined trigger level, AT1 bonds are issued as perpetual securities with a call date set after a minimum of five years. The call feature provides the issuer with the option of not having to call and refinance with a new AT1 bond, at current market levels. However, unless the issuer's balance sheet has weakened, it is expected that they will call and refinance at the first call date.
However, the recent rise in yields led investors to become concerned that calling and refinancing would not be economically viable due to the higher coupon required for new issues. This caused many AT1s to start being priced to perpetuity rather than to call which drove spreads wider still. To sustain investor confidence all bonds in the iBoxx USD Contingent Convertible Liquid Developed Market AT1 (8% Issuer Cap) Index that reached the first call date in 2022 were called. This acted as a catalyst for confidence to return to the AT1 market once yields across fixed income peaked and caused AT1 spreads to rally aggressively from October.
Here is an example of how you can invest in AT1 bonds, with an ETF
ID: IE00BFZPF439
The objective of the Fund is to aim to track the Total Return performance of the iBoxx USD Contingent Convertible Liquid Developed Market AT1 (8% Issuer Cap) Index, less fees, expenses and transaction cost. With a 0.39% of ongoing charge p.a., this ETF offers a yield to maturity of 8.70%.
It measures the performance of financial institutions' AT1 contingent convertible debt and aims to offer a broad coverage of the USD AT1 capital bond universe whilst upholding minimum standards of investability and liquidity.
Additional Tier 1 bonds, or AT1s for short, are part of a family of bank capital securities known as Contingent Convertibles or ‘CoCos’. They are bonds issued by banks that contribute to the total level of capital they are required to hold by regulators.
Let’s now see the risks of AT1 CoCo bonds and some historical events about this financial instrument.
AT1 CoCo BONDS AND THE CANCELLATION OF BANCO POPULAR’S AT1 CoCo BONDS IN 2017
▪ What is an AT1 bond CoCo?
AT1 CoCo bonds, i.e., Convertible Contingent Bond additional Tier 1, "are in practice convertible hybrid bonds that, under certain conditions, are transformed into shares; therefore, in the capital of the bank that issued them, substantially lightening the debt exposure. Coco bonds are therefore debts that become capital when necessary, when, for example, the core tier 1 ratio, the main indicator of banks' capital solidity, slips below a pre-established threshold. In exchange for this increased risk that is passed on to the investor, higher returns are expected." (Source Consob)
▪ Let's see a practical example
"The Deutsche Bank case.” One of the big banks that have used this tool in recent years risking creating a systemic crisis has been Deutsche Bank. In 2016 it emerged from journalistic investigations that the German financial institution had an exposure to derivatives of several trillion euros (some claimed about 75 thousand, or 20 times the German GDP). The financing mechanism used was precisely that of CoCo Bonds. In essence, the bank had issued convertible bonds with coupons ranging from 4% to 6%, linking convertibility to Core Tier 1 of 5%.
These securities were mainly purchased by pension funds and insurance companies. Why? The reason was basically dictated by the fact that, in order to pay periodic and redemptions from the fund and claims, a constant and perpetual flow of money was required; and CoCo Bonds could guarantee it. The problem, however, was that the Frankfurt investment bank was in bad waters and market shares were plummeting. What would convertibility entail? That investors risked finding heavily devalued invested capital and, given that they were important institutions with social repercussions, the consequences could have been dramatic. (Source Investire.biz)
▪ Risks associated with Coco bonds
There are two types of risks in this asset class, those that are known in advance (trigger level, coupon frequency, leverage, issuer credit spread, instrument rating) and those that are difficult to assess, unknown a priori (individual regulatory requirements in relation to the capital buffer, future capital position of the issuer, issuer behavior in relation to coupon payments, risk of contagion). If at some point the financial entity does not comply with the Tier 1 capital ratio, it may redeem the bonds. If at that time the shares are below the agreed price, the bondholder will see his investment reduced. It will become a shareholder of the entity, with the corresponding political and economic rights (dividends).
One of the potential risks we can suffer is at the time of the exchange. When trading from bonds to shares takes place, we will become shareholders of the entity at a price determined in the prospectus when we take the convertible bond. If the market price at that time is lower than the agreed price, we will have a loss, if instead, at the time of the exchange, the market price is higher than the agreed price, we will have an additional profit.
However, other risks associated with investing in Coco Bonds include:
→ CoCos may be converted into shares of the issuing financial institution or be written down of their capital. This may result in the loss of part or all of the initial investment.
→ The relatively new behavior of the coco bond market has not been tested in a systemic financial crisis, so the price and liquidity of coco bonds could degrade under such circumstances. Therefore, past performance is not an adequate indicator of future performance.
→ Coupon payments of some CoCos are completely discretionary and can be canceled. Because of this uncertainty about coupon payments, Coco bonds can be more volatile, and their price can fall rapidly if coupon payments are suspended.
→ Some CoCos may be callable bonds, which means that the issuer may decide to redeem those callable bonds before the bond matures. This may result in the investor not receiving the invested capital on the specified recall date or on any other date.
→ Some CoCos are issued as perpetual instruments and are callable only at predetermined levels with the approval of the competent regulatory authority. It cannot be assumed that these perpetual CoCos will be recalled on the expiration date. CoCos are a form of permanent capital. (Source Rankia).
BANCO POPULAR RESCUE THANKS TO BANCA SANTANDER
From this rescue chronicle, it is highlighted how much the other international banking systems are more efficient than our country, highlighting the speed of the bureaucratic system, the subject of great shortage in the beautiful country.
A few years ago, in 2017, one of the largest Spanish banks, Banco Popular (the sixth largest banking institution in Spain) was rescued thanks to the intervention of Banca Santander. The crisis that was affecting Banca Popular is very similar to that of Monte dei Paschi di Siena and the two Venetian banks. It resulted from the real estate crisis caused in 2007-2008, which led to a heavy hereditary crisis to the Spanish giant, coming to lose in 2011 a figure of around 3.5 billion euros and 40 billion bad loans. In 2012 the bail-out was proposed, or the rescue of an institution that is in a state of insolvency, through economic support, where in the case of Popular, it was rejected by the administrators because they wanted to settle the issue internally trying in 2012 and 2016 to carry out capital increases (3.2 billion in 2012 and 2.8 billion in 2016, but which were burned completely, in the week of the decline on the stock exchange, bringing the value of the capitalization to 1.5 billion). Until 2017, when the bank lost half of its value on the stock exchange within a week, those who worked for the ECB's Single Resolution Board realized that the bank would no longer be able, soon, to pay its debts and other liabilities, declaring the bank bankrupt or probable bankruptcy. This was the first application to an institute of European rules on resolution, this was because the ECB no longer tolerated systemic crises that could trigger further infections. Furthermore, we highlight that this procedure, of a private nature, that is, without the use of public resources and without producing a possible contagion for the sovereign risk of the State and for the banking one, allowed in 48 hours, to resolve the issue with the acquisition of the Popular bank to Banca Santander for a sum equal to 1 euro , where Santader will subsequently add a €7 billion capital increase to adjust capital levels and clean up Banco Popular's balance sheet. Some will surely wonder what the advantage for Santander was to acquire the bank. The president of Banco Santander explained that with the purchase of the Popular an operation was carried out that "will give certainty and stability to the Spanish financial sector, with an expectation of return on investment equal to 13%-14% by 2020". Botin pointed out that for the first time an entity in crisis is taken over under the new European regulation and without using public money. The operation, he insisted, "will have no cost to taxpayers." The banker then reassured the customers of the Popular for whom "nothing will change". The merger, he added, "will be good for Spain, for Europe, and will contribute to the growth of the Spanish economy”.
Banco Popular is the first instance of credit loss in the AT1 sector.
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