What is the future for Additional Tier 1 bonds?

After the CS write-off event, AT1 bonds have sold off and yields for AT1 bonds have peaked close to Covid-19 levels. Currently, AT1 bonds have a Yield to Worst (“YTW”) of 13.5% (Chart 1). The previous time AT1s were trading at these levels was during the Covid-19 recession in 2020. Higher risk have been priced into AT1 bonds due to the current turmoil in the banking sector. The full write-off of CS AT1 bonds ahead of its equity shareholders also puts in question the capital structure hierarchy of AT1 bondholders. The uncertainty in how AT1 bondholders will be treated during a viability event have been priced into AT1 bond yields.

Taking a look at the various type of loss absorption in SGD AT1 bonds (Table 1), there are varying levels of “strictness” for the type of loss absorption an AT1 bond will receive. Swiss banks in particular have strict loss absorption clauses where AT1 bonds will be written down permanently as compared to French AT1 bonds from Societe Generale and BNP Paribas where there is a temporary write down clause. A temporary write down means that in an event of a write down in AT1 bonds, the principal amount of the AT1 bonds written down may be replenished by the bank at its discretion upon a recovery of the bank’s financial health. With that said, we think it is unlikely that principal amount will be replenished when a bank faces insolvency. Thus, it is best to assume that AT1 bonds will be fully written down during an insolvency event.

In light of the full write-down of CS AT1 bondholders ahead of its equity shareholders, regulators have issued statements to calm AT1 bondholders. Singapore’s MAS released a statement to say they will abide by the hierarchy of claims during a liquidation. This means that equity shareholders will absorb losses first before AT1 and Tier 2 bondholders. Similarly, European and UK banking regulators issued similar messages to AT1 bondholders. The Single Resolution Board, the European Banking Authority and the ECB Banking Supervision in a joint statement stated that creditors will only bear losses after equity holders have been wiped out while the Bank of England stated that the UK has a clear statutory order for bearing losses with AT1 bonds ranking ahead of equity shareholders.

All in all, when investing in AT1 bonds, investors should understand the risk involved. AT1 bonds are capital instruments that banks issue in order to have bondholders absorb losses during an insolvency event. Therefore, at any point in time, it is at the discretion of the bank and regulators to write-off these bonds during a viability event. While statements from regulators may have calmed AT1 bondholders, during a liquidation event, AT1 bondholders should still expect write-downs in AT1 bonds together with equity holders. 

Looking ahead, we expect future AT1 issuances to be much more expensive going forward. Investor’s confidence in these bonds have been shaken, not only due to the write-down of the bonds but also how regulators ignored the hierarchy of claims. AT1 bonds may not differ much from equity as initially thought and this increased risk may be priced in future AT1 issuances.  

Table 2: Various loss absorption features in SGD AT1 bonds

Higher non-call risks for AT1 bonds

As AT1 bond yields have risen after the events of CS, majority of SGD AT1 bonds within our coverage have become more expensive to refinance. In the past, banks have regularly called back their AT1 bonds on its first call date and replaced it by issuing a new AT1 bond. Investors should not assume that every AT1 bond will be called back on its first call date. It is at the discretion of the bank to call back the bond as ultimately it is a perpetual bond in nature.

AT1 bond spreads have widen in recent times due to the events of CS and this made issuing of new AT1 bonds much more expensive than before. Therefore, banks may not be incentivised to redeem their AT1 bonds on their first call date and choose to have the bond reset instead. We are cautious on the extension risk for AT1 bonds with nearer call dates as refinancing these bonds may be costly for the bank and the bank may opt to have the bond reset instead. Last week, Deutsche Pfandbriefbank AG, a German real estate lender, opted to miss its call date and cited that market conditions and economic costs were the factors that led to the non-call. As it will take some time for market sentiment to cool from the recent turmoil in the banking sector, we expect to see more non-calls for AT1 bonds in the near future.

While spreads of AT1 bonds have widen, we still think it is not reflective of the risks AT1 bonds entails. As most AT1 bonds are rated a few notches from the bank’s issuer rating, most AT1 bonds are non-investment grade. The initial spreads of the AT1 bonds should reflect the high yield nature of the bond. Currently, high yield USD bonds are trading at a spread of 480 basis points (“bps”) above benchmark rates and we think AT1 bond spreads should be reflective of that. A high initial spread will properly compensate the risk when investing in AT1 bonds and reflect yields close to the cost of equity of banks.

For investors who want to take on risk in investing in AT1 bonds, we prefer AT1 bonds with high initial spreads above 500 bps. The BACR 8.300% Perpetual Corp (SGD) has a high initial spread of 564 bps. The bond also has a further call date in 2027 which will allow AT1 bond markets to stabilise and allow the bank to refinance it at a cheaper rate. At a coupon of 8.30%, we think it is reflective of the risk that AT1 bonds entail and investors will be compensated for investing in these risky bonds.

Lastly, we would like to end off on two key takeaways – 1) AT1 bonds are bank capital instruments that banks issue to absorb losses during an insolvency event and loss absorption should be expected whenever a bank is liquidated. 2) As AT1 bonds are perpetual in nature, it is at the bank’s sole discretion to call back the bonds and it should not be assumed that the bond will be called back on its first call date.

Table 3: Cost of issuing new AT1 bonds have risen

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a position in BACR 8.300% Perpetual Corp (SGD), HSBC 5.300% 14Mar2033 Corp (SGD), OCBCSP 3.900% Perpetual Corp (SGD), UBS 5.875% Perpetual Corp (SGD), UOBSP 2.550% Perpetual Corp (SGD), UOBSP 4.250% Perpetual Corp (SGD), HSBC 6.500% 20May2024 Corp (GBP), STANLN 4.300% 19Feb2027 Corp (USD), HSBC 4.375% 23Nov2026 Corp (USD) and the analyst who produced this report holds a NIL position in the abovementioned securities.