After an eventful financial crisis and a flurry of bank bailouts around the world, regulators have worked to redefine the capital requirements, introduce more relevant liquidity metrics and impose more stringent ratios for the Systemically Important Banks (SIBs, aka those ‘’too big to fail’’). Multiple regulations have been drafted in this respect with Basel III (or its European equivalent, CRD IV) being only one of the examples and national regulators (most notably those from UK and Switzerland) striving to be ahead of their global peers and adopting a harsher stance, particularly for the SIBs.
Such changes have several implications for bond investors. To start with, these changes are deemed to make the banking sector safer by increasing the common equity buffer and disincentivising banks from relying extensively on short term financing (which can unexpectedly drain if risk aversion spikes for some reason).
However, authorities are also working to make sure more “bail-inable” capital is available, which means increasing risks for the more subordinated bondhodlers. Moreover, regulators have also changed the eligibility criteria for capital instruments. As such, bonds which were previously eligible are now gradually phased-out and new types of instruments have emerged.
In the first category we have got subordinated perpetual bonds with deferrable coupons (Tier 1, T1 and Upper Tier 2, UT2) and dated subordinated bonds (Lower Tier 2, LT2). Since the coupons of such instruments are rather chunky, the banks have a high incentive to call them or, in the case of LT2 bonds which do not always have this feature, try to persuade investors into tendering them.
As such, many of these instruments are now perceived as short term bonds but, given their subordination, they offer a spread pickup in comparison to the senior bonds. It should thus come as no surprise that these bonds have proven quite resilient over the last few months and that they are becoming increasingly appealing in this yield-starved environment. To give just a few examples, 6.117% BPCE Perpetual yields 2.2% to October 2017 call, 8.047% Intesa Sanpaolo Perpetual yields 3.22% assuming it is called in June 2018 and 4.75% Barclays perpetual yields about 4% (call March 2020).
On the other hand, the shift in regulation has brought to market new Tier 1 instruments (i.e. the most subordinated in the banks’ capital structure), dubbed Additional Tier 1 bonds (AT1). Such bonds share some similarities with the old style Tier 1, such as being perpetual and having deferral coupons but they carry additional risks. AT1s are automatically converted into equity when the core capital ratio (CET1) falls below a given threshold, defined in the prospectus, while the timing of the coupons’ suspension is to some degree at the discretion of the issuer.
The AT1 market has been on the rise and is now valued at about EUR70 billion, including around 60 notes across different currencies. These instruments have however different trigger levels and in some cases different definitions. At one extreme we find AT1s for which the conversion trigger is 5.125% CET1 while for others the threshold is as high as 8%. Naturally, issuing an instrument with a higher threshold comes at a cost (higher coupon) for the issuer so that the natural question is why should some take such a cost.
In my opinion this reflects the ongoing tightening in capital requirements, particularly for SIBs. The latter have been under increasing scrutiny with additional and more demanding capital buffers mandated for them. Indeed, some SIBs, such as Rabobank and Danske Bank will face minimum capital ratios of 10%, Barclays 9% and Credit Suisse and UBS 8.5%. Even the ECB’s stress tests have considered a minimum CET1 of 5.5%, above the 4.5% introduced by Basel III.
Another consideration is that there has been increasing focus around regulators’ power of mandating AT1s’ conversion when the issuer reaches the Point of Non Viability (PoNV). The latter is not quantitatively defined but is rather at the supervisor’s discretion to assess when this was reached. Again, given the drive to further increase regulatory requirements, it has become increasingly likely that, for the AT1s with low triggers, the PoNV is of greater concern.
Here is where I think the opportunity might lay. In my opinion the AT1s with such structures are increasingly likely to be called (typically at par), resulting that the risk of a conversion would be lower than otherwise (lower probability over a shorter time horizon than over a longer one). There are a handful of bonds with a 5.125% trigger, among which 6% Deutche Bank Perpetual, 5.625% KBC Perpetual and 6.25% Stander Perpetual.
Having said this, I caution that AT1s are complex instruments and that in certain cases investors face the risk of a mandatory deferral in coupon even when CET1 is above the regulatory minimum. They are thus appropriate for investors with adequate expertise and are not targeted for retail investors.
On a related note, my opinion is that the move towards higher capital ratios also makes the dated contingent convertible instruments (LT2s with a trigger) more prone to a call. Such bonds are fairly rare as they are issued mainly by Swiss banks which are subject to different requirements and can make (limited) use of such instruments to meet their leverage requirements.
However, the latest rhetoric of the local supervisors suggests that they increasingly favour Tier 1 instruments and/or high-trigger LT2. Thus, in my view LT2 bonds with low conversion triggers (5%) are likely to be called; such bonds are 5.75 Credit Suisse 2025 (yield 2.5%, call 2020), 4.75 UBS 2026 (yield 2.5%, call 2021) or, in USD, 7.25 UBS 2022 (yield 2.85%, call 2017) and 4.75% UBS 2023, all of which carry an Investment grade rating.
Raluca Filip is Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.
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