The chart
Despite its compelling credit quality and fundamentals, the AT1 market today offers historically high yields - even when compared with single-B rated high-yield bonds.
Source: Bloomberg, Ninety One. 30 Sept 2023. AT1s = Bloomberg Barclays EUR Contingent Capital Index. EUR high-yield corporate bonds = Bloomberg Barclays EUR B High Yield Index.
The context
Earlier this year, turmoil in the market for bank capital debt (AT1s) hit the headlines in the context of Credit Suisse’s collapse, as discussed in our Credit Chronicle. While a partial recovery has taken place since March, risk premia in the asset class remain relatively high.
The average credit rating of AT1s is significantly higher than that of single-B rated high-yield corporate bonds, yet the two markets have historically traded at similar yield levels. There are several reasons for this. In part, it is down to the structural features of AT1s. Unlike traditional corporate bonds, AT1s (bank-issued debt instruments – commonly referred to as Contingent Convertibles, or CoCos) can be converted to equity or written down to absorb losses in certain circumstances, such as the issuing bank coming under severe financial stress. Another factor is that investors in AT1s require compensation for ‘extension risk’ – this relates to the possibility that the issuing bank won’t call (redeem) the bonds at the first call date, increasing the risk for investors.
Over the past five years, Euro-denominated AT1s have offered 23bps more yield on average than high-yield (B rated) European corporate bonds. Yet this differential has widened dramatically to c.250bps – making AT1s significantly cheaper on average than single-B rated bonds. That’s despite the average credit rating for AT1s being around three notches higher than that of single-B rated corporate bonds. A similar dynamic is in evidence in the US dollar-denominated AT1 market; in both cases, the market appears to be overestimating extension risk.
The conclusion
At current valuations, we think AT1s represent one of the best-value asset classes within global credit markets. They appear attractively valued – not just relative to corporate high-yield bonds, but also when compared with other parts of banks’ capital structure, including senior and T2 debt. Selective investors can seek to benefit from this relative-value opportunity within a wider global credit allocation.
Market technicals (supply/demand dynamics) are also becoming more supportive for the AT1 market. Over recent months, most issuers have been calling their capital instruments, and issuance has been largely for replacement purposes. We have even seen a few issuers call instruments without replacing them (creating net-negative issuance). A similar phenomenon has benefitted markets such as high-yield debt this year, as we wrote about in a previous edition of Picture this.
Furthermore, the elevated yield premium in the AT1 market suggests that the market is overestimating the underlying risk and overlooking the solid fundamental health of the overall European banking sector. However, this is a diverse investment universe and investors need to be selective; while some areas of the market appear fragile, fundamentals remain resilient for the large, national champion banks, which we believe will be able to weather an economic storm better than lower-rated high-yield corporates. We believe investors should focus on AT1s from higher-quality issuers, where we believe extension risk is still overstated.
Past performance is not a reliable indicator of future results. The value of investments, and any income generated from them, can fall as well as rise.
