Revisiting AT1 bonds

Also authored by Ian Centis, Senior Analyst, Invesco Fixed Income.

The history and idea of AT1s

In an attempt to reduce the risks and potential taxpayer costs of future banking crises after the Global Financial Crisis, national banking regulators imposed higher capital requirements on banks under the 2010 Basel III accord. In meeting those capital standards, banks developed different types of specialised debt securities. 

Europe developed a new asset class called Additional Tier 1 (AT1) bonds, also known as contingent convertible bonds, because they can be converted into equity or partially or fully written down temporarily or permanently, depending on each individual bond’s terms. The term AT1 refers to the placement of securities in the capital structure of banks in a subordinated position. They sit below ordinary, senior debt and subordinated, tier 2 debt, but above equity in banks’ capital structure. The Additional Tier 1 capital is intended to supplement a bank’s common equity as a buffer to absorb losses. Tier 1 securities that existed previously were gradually withdrawn as, in the Global Financial Crisis, they were found to be ineffective in absorbing losses.

Large banks with complex capital structures have various equity and junior subordinated capital classes, of which Additional Tier 1 is the main tangible, loss-bearing slice. In the event of significant financial distress, if loan loss reserves and provisions prove insufficient, common equity tier 1 absorbs further losses. In addition, AT1 bonds can be converted into equity, for example, to meet bank capital requirements after equity is written down to absorb losses. Alternatively, they can be written down themselves completely or in part to help absorb losses along with Tier 1 equity. Furthermore, AT1 coupons (which are not cumulative) can be suspended. Another feature of these securities is that they can be extended past the call date, potentially even into perpetuity.

The loss-absorbing mechanism of AT1s is triggered if the issuing bank’s common equity tier 1 (CET1) capital falls below a specific threshold, converting them into equity or triggering a write-down. This loss-absorption capacity of AT1s represents a ‘bail-in’ feature’. AT1s aim to reduce the need for taxpayer-funded bank bailouts in the event of excessive losses which expose the bank to the risk of runs on deposits, interbank funding or loss of access to long-term bond or equity financing.

AT1s, the role of banks and banking crises

Of course, banks are highly leveraged with debt/equity ratios often in the double digits. These ratios can be several times the size of those of conventional firms. Furthermore, banks tend to ‘borrow short and lend long’ to fulfil their function of transforming savings into loanable resources to finance the spending of firms, households and sometimes governments. As a result, banks’ funding sources – retail or corporate deposits, wholesale funding from the interbank market, or bonds – tend to be more short-term, more liquid and potentially more quickly withdrawn than loans are repaid.

Banks’ ability to leverage their own capital and creditors’ resources with a diversified loan book, allows them transform short-term savings into long-term funding to support far more economic activity than unleveraged or undiversified savers themselves. As such, well-managed, well-diversified, well-capitalised banks are central to economic growth. However, excessive leverage, concentration or major downturns can hit banks hard. And if the economic hit is strong and widespread enough, good lending decisions can go wrong across the board.

In economic downturns or when interest rates rise rapidly, bank asset quality or valuations can fall quickly and sharply while debts are redeemable at par – and for many deposits or interbank loans, on demand or within days. Depositors or other bank creditors may fear that banks won’t be liquid enough to meet withdrawals, especially if they think there isn’t enough equity to absorb losses. This means that banks are exposed to the risk of runs. In other words, they can rapidly go from liquid (plenty of cash available) to illiquid (too little cash) to insolvent (losses exceeding absorption capacity).

This can spell disaster for a bank’s stakeholders, contaminate other banks and damage the economy in a severe crisis. Such risks have come to the fore in recent weeks with the crises faced by US regional banks like SVB and Signature, as well as Credit Suisse, a large global bank. It should be noted, though, that Credit Suisse had no asset quality problem and was well-capitalised. It was brought down by a liquidity crisis, as its mostly large (and therefore uninsured) depositors suffered a self-feeding crisis of confidence. This came against a backdrop of poor governance and profitability, adverse market commentary and instability triggered by events around SVB.

A key goal of state support during banking crises is to prevent or stop bank runs. AT1s are intended to reduce the need for such bailouts and to avoid ‘creditor moral hazard’. This is the risk that banks or their creditors may take too much risk, expecting to be bailed out by governments in a serious crisis. As a result, AT1s can strengthen banks’ financial position by reducing debt and boosting their equity loss-absorption capacity at times of extreme stress, while preserving deposits and other creditors – ideally without recourse to government funding.

Financial features and benefits of AT1s

AT1 bonds are perpetual bonds. They never mature, paying only interest indefinitely.  However, they are callable and the market was designed with the expectation that issuers would call (and refinance) their AT1s at the first call date. AT1 bonds include a feature that allows interest payments to be skipped if the bank’s capital ratio falls below a specific percentage or if the bank is experiencing losses.

AT1 bonds are typically issued by large financial institutions carrying investment grade issuer ratings. However, because of the unique nature of AT1 bonds (especially their subordinated status and their write-down risk), they typically carry a high yield rating. AT1 bonds not only have high yield ratings but also offer higher yields than more senior debt from the same issuer to compensate for their unique risk profile. The extra yield is reward for balance sheet risk rather than credit risk.

AT1 bonds have historically offered lower interest rate sensitivity than other fixed income asset classes due to their callable nature. AT1s have also historically exhibited relatively low correlations to IG and government bonds (Figure 1), probably reflecting their rare if not unique combination of low interest-rate risk with exposure to the banking sector’s gearing to the overall macroeconomic cycle and large banks’ credit-exposure profiles. In times of stress, however, they can correlate to bank equity moves, reflecting their convertibility into equity.

Though AT1s are issued by European banks, they are largely denominated in US dollars, which introduces a currency element to the investment decision.

Investment risks of AT1s

As with any liabilities issued by banks, the pricing of AT1s is likely to be impacted by economic, credit and banking cycles. Economic downturns usually increase defaults on the loans offered by banks to their customers, which increases the need for bank capital and usually reduces the valuations applied to bank sector equity and bond liabilities. Rising central bank interest rates can contribute to economic weakness but can also negatively impact the operational performance of banks when yield curves flatten, and especially when they invert (given their asset-liability term mismatch).

The write-down risk is a relatively low-probability but high-impact risk. Since their creation, there have only been two write-downs: the 2017 takeover of Banco Popular by Banco Santander and the 2023 takeover of Credit Suisse by UBS. However, it should be noted that AT1s came into existence a relatively short time ago and have not yet been tested across a broad range of economic scenarios. For example the iBoxx USD Contingent Convertible Liquid Developed Market AT1 index was launched on 31 December 2013. Meanwhile, the phase-in of the Basle III standards started on 1 January 2013).

A new risk was added to the mix in March, when the Swiss regulator, Finma, made an unexpected decision by choosing to have Credit Suisse’s AT1 bonds written down to zero, yet allowed some recompense for Credit Suisse stock. Investors expected equity holders to be zeroed out as well, if AT1s were written off. Instead, the ultimate compensation offered to Credit Suisse equity holders was much higher than initially offered by UBS.

Technically, it appears that the AT1 write-off decision is consistent with CS AT1 terms. These allow for the state to write down AT1s completely at the ‘Point of Non-Viability’ (PONV) in the event of significant state support when the bank is no longer a going concern.

Yet it remains somewhat unclear why the equity was in effect ‘written up’ during the takeover talks. One theory is that pressure from foreign investors, who are often buyers of major bank equities in periods of stress, led to a negotiated equity valuation. This might mean that the AT1 decision and the equity decision went on two separate tracks. Alternatively, there may have been a desire to avoid extreme equity losses for some shareholders. This possibility initially left investors worrying about a precedent overturning the capital structure by prioritising common equity above AT1s, which are supposed to be no more than another form of equity in crisis.

Not all AT1s are created equal

Crucially, other European authorities have stressed that this is not how they would treat AT1 bonds. In a joint statement on March 20th, the European Central Bank, the European Banking Authority and the Single Resolution Board confirmed that, for those banks under the EU’s jurisdiction, AT1 bonds would only be written down after all common equity tier 1 capital had been exhausted. The Bank of England also issued a similar statement.

It's worth noting that EU bail-in procedures are governed by EU law which, unlike national law, cannot be easily changed in an emergency (as Switzerland did). The relevant authorities would need to consult national central banks and regulators, member-state governments and EU institutions. This EU peculiarity can cut both ways. The EU structure makes it harder to respond to a financial crisis quickly, which is crucial in a crisis and was a real challenge during the Eurozone Crisis in 2009-12. More positively, rules of engagement once established are more likely to be adhered to, reducing regulatory, legal and political risk. On net, we believe EU authorities have demonstrated strong commitment to existing rules and have become much more responsive to macro and financial shocks, as shown by the rapid modification of state-aid rules and fiscal deficit rules during the pandemic lockdowns and wartime energy crisis.

Despite doubts following the decisions of the Swiss authorities, we expect clear commitments by the EU and UK, the two main jurisdictions for AT1 issuance, to reassure investors. However, the Credit Suisse experience and approach of the Swiss authorities confirms a need for due diligence when looking at bond contracts. It also calls for closely monitoring the regulatory and supervisory stance as well as bank issuers.

The implications for investors

We believe AT1 bonds are worthy of consideration by institutional investors seeking higher yields within a diversified fixed income sleeve, potentially diversifying exposure to senior debt.

AT1s are hybrid securities that combine the characteristics of both bonds and equities, making for an unusual risk/reward profile and potentially serving as an innovative, alternative source of income along several dimensions. AT1 bonds have historically offered higher yields than most traditional bonds with lower interest rate risk thanks to the call feature – though with greater risk of write-down (or equity conversion) in a banking crisis.

AT1s have scheduled interest payments, like traditional fixed income, but are issued as perpetual securities that can be called after a minimum of five years and at regular intervals thereafter. Meanwhile, the interest payments can be suspended without triggering a default event, similar to common equity dividends. As such, AT1s sit low in the capital structure of banks, which helps both drive their higher yield, while their quasi-equity features and low interest rate risk contribute to their historically low correlations with senior debt.

After a steep sell-off, reflecting market dismay at the treatment of Credit Suisse AT1s, the iBoxx AT1 Index has rebounded somewhat following the EU/BoE reconfirmation of the traditional position of AT1s (i.e., below banks’ senior debt but above common equity). However, a substantial discount persists. This probably reflects a mix of factors, such as the heightened risk of further AT1 write-downs given that monetary tightening and slowing growth could well increase bank capital losses. Furthermore, the Credit Suisse situation has impacted the reputation of the asset class. While this has the potential to improve over time, it could also further deteriorate in the near term if aggressive monetary policy results in more stress on some banks.

Our conclusion is that AT1s are interesting from a strategic perspective, especially for investors looking to add yield. However, we have to recognise that they may face short term headwinds due to economic and bank cycle considerations.

Investment risks

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

All data is provided as at the dates shown, sourced from Invesco unless otherwise stated.

This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. Views and opinions are based on current market conditions and are subject to change.