Why AT1s could now be attractive after withstanding last year's policy tightening

Key takeaways
The 2022 selloff has driven yields across many fixed income asset classes to the highest levels seen in over a decade. However, fixed income markets bounced in the fourth quarter as the combination of high yields, wide spreads, and rates closer to the peak attracted investors back to bonds.
For the AT1 bond market, yields have risen from lows of 3.1% in September 2021 to end 2022 at 9.2%, having peaked at just over 11% in October1. The Q4 rally was primarily driven by spread tightening which now appears to be stabilizing. This may increase confidence in the asset class and make it an attractive opportunity.
Despite the volatility early in 2022 and a considerable rise in yields, the AT1 market is behaving as anticipated, with bonds being called and refinanced even when, at first glance, it may not appear economical to do so.
For most of 2022, determining the right time to buy fixed income felt like trying to catch a falling knife, as yields continued rising, driven by increasingly hawkish central banks and their concerns over inflation. However, sentiment towards fixed income started to change in the fourth quarter as yields hit decade highs, credit spreads had widened, and market participants anticipated that rates were close to the peak as US inflation had started trending lower. Fixed income markets have started 2023 on the front foot, with yields rallying throughout January. So, what is the outlook for AT1s?
What are AT1 capital bonds?
Additional Tier 1 contingent convertible bonds (“AT1s”) are securities issued by European financial institutions. First introduced following the global financial crisis, AT1s were designed to prevent contagion in the financial sector by acting as a readily available source of bank capital in times of crisis. AT1s tend to have higher yields and low correlations with traditional fixed income, making them a useful diversifying asset class.
Source: Invesco, Bloomberg, as of 25 Jan 2023, based on the yield to worst on the Bloomberg Contingent Convertible USD Index.
AT1 spreads have been rallying
As with other credit markets, AT1 spreads have been rallying since October having widened to cheap levels. For AT1s specifically, the rise in yields last caused investors to start questioning whether they would continue to behave in the way that they were designed.
Following the global financial crisis, new regulations were introduced that required European banks to issue AT1s as part of their regulatory capital. The regulation also harmonized the AT1 market relative to the previous Tier 1 capital by setting specific characteristics in their design. In addition to a specific trigger level, AT1s are issued as perpetual securities with a call date after a minimum of five years. That call is designed to provide the issuer with the flexibility to not have to call and refinance with a new AT1 at prevailing market levels. However, expectations are that, unless the issuer’s balance sheet has weakened, they will call and refinance at the first call date. Due to this, AT1 characteristics such as yield, and duration are priced to call rather than to perpetuity.
However, the rise in yields last year caused investors to become concerned that calling and refinancing would not be economically viable due to new issues requiring a higher coupon, and that issuers may choose to leave their current AT1s outstanding. This caused many AT1s to start being priced to perpetuity rather than to call which drove spreads wider still.
To retain investor confidence and to avoid their balance sheets being analyzed ever more closely, 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.
Source: Invesco, Bloomberg, as of 25 Jan 2023, based on the option adjusted spread on the Bloomberg Contingent Convertible USD Index.
The AT1 market has matured
Following a period of rapid growth driven mainly by regulatory requirements, the AT1 bond market is now maturing as an asset class. Liquidity and market efficiency have improved in recent years and the total amount of AT1s in issue is likely to remain relatively stable going forward.
The main risks around AT1s are the reason for the additional yield on offer. As subordinated debt, they could be converted into cash or equity if capital drops below a trigger level. But this means the higher yields are driven by subordination, rather than issuer quality. Given AT1’s callable nature and as demonstrated above, interest rate risk is also relatively low and constant.
However, European banks are now well-capitalised. In the decade following the Global Financial Crisis, banks both reduced the size of their balance sheets and improved the quality of assets held, and increased capital held against risk-weighted assets. Banks now have plenty of capital in excess of their CET1 trigger levels and sufficient accumulated retained earnings, minimizing risks around conversion and coupon suspension. The AT1 market is functioning as expected, with bonds being called and refinanced even through the recent Covid pandemic and the current Russia/Ukraine crisis.
AT1s: an attractive time to take another look
Yields and spreads on AT1s are at historically attractive levels and, while they have bounced from the widest levels, that market stabilisation could actually generate further confidence in the market as the uncertainty whether bonds will not be called falls. At the same time, European banks are now in a stronger, more resilient position to deal with market volatility. As inflation continues to fall and interest rates appear close to the peak, bond markets have stabilised making now a good time to take another look at AT1s.
Sources
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1
Invesco, Aladdin, as of 25 Jan 2023. Yield is the yield to worst for the iBoxx USD Contingent Convertible Liquid Developed Market AT1 (8% Issuer Cap) Index.
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2
Invesco, Aladdin, as of 23 Jan 2023. Yield is the yield to worst for the iBoxx USD Contingent Convertible Liquid Developed Market AT1 (8% Issuer Cap) Index.
Investment risks
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Important information
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