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- AT1 - beneficial wake-up call
This week most people will have learned more about AT1 – Additional Tier 1 capital – than they could wish for. For some market professionals the lesson was harsh: they learned they probably should have cared more. This hybrid instrument, midway between equity and bonds, provoked widespread confusion, diplomatic tensions and some trading opportunities as a result of hefty price swings in markets.
Initial concern that the ruthless haircut for AT1 bondholders à la Suisse would become the norm in the rest of Europe (which in this case included the UK) subsided in the course of the week. This was not only due to reassuring comments from European supervisors, but also to a Swiss peculiarity in dealing with AT1 bonds. Switzerland has a wider definition for the event of stress for the AT1 bonds, which can mean a write-off. But it still required a firm interpretation of the rules by the Swiss government to precipitate the writing off the entire stock of AT1 capital even without the equity capital having been written off before.
Coco bonds have never been as cheap (or yields as high) compared to equity
* Earnings per share (estimates for the next 12 months; MSCI Europe Banks) divided by share price
** difference between equity yield and CoCo bonds YTM
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 3/22/23
Nevertheless, pessimistic investors will take away from this episode that laws can be applied flexibly in case of emergency. And bond investors are by profession pessimistic in that they tend to be risk-averse. Therefore, we expect refinancing via AT1s to become more expensive for banks, though not at the current particularly expensive level, which still reflects the immediate Swiss shock. This is shown in our Chart of the Week by the record low difference between the yield on CoCo bonds (which constitute the majority of AT1 capital) and the earnings yield on bank shares.
But a reassessment of the segment seemed overdue anyway. When AT1 bonds were introduced as an additional way for failing banks to absorb losses to save taxpayers' money, Europe's banks held a common equity tier one capital (CET 1) of 5-6%. Today it is almost double that. We do not expect that conversion into equity capital in the sense of the regulations – if the CET 1 ratio falls below 5.125% – will ever happen. The regulator would probably take action before that.
Irrespective of this, the recent events are likely to make every bank keen to strengthen its capital base to avoid coming under the markets’ scrutiny. More reassuringly, the European banking sector is not doing so badly, not only by comparison with 2007-08, but also in comparison with the U.S. now[1]. This, combined with the market turmoil of recent days, has led us to overweight investment grade euro bonds – even though we assume that the market might remain volatile.
