Fixed IncomeAug 19 2014

Fixed Income View: Appeal of AT1s and CoCos

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Contingent Convertible (CoCo) and Additional Tier 1 (AT1) are relatively new types of debt products and, in spite of their more complex structures, they have been embraced by fixed income investors as a way of capturing attractive yields.

In order to attract a wide range of investors, AT1s have consistently been issued at yields higher than that of traditional vanilla high-yield corporate bonds.

As an example, the average lowest potential AT1 yield was 7 per cent in January compared to only 4.3 per cent for high yield, but as a consequence they have always been prone to be more volatile when the market went through a period of stress.

AT1s have also generally been issued in much larger sizes than traditional high-yield bonds, with most placements being at least £500m in size and many exceeding £1bn. Consequently, they are more likely to experience selling pressure.

So how have AT1s performed? Looking at the period from June 25 (when the sell-off started), and using the Bank of America Merrill Lynch indices, the Euro High Yield index has fallen by 1.8 per cent, but is easily eclipsed by the CoCo HY index (a good proxy for AT1), which has sold-off by 4.1 per cent.

So with this in mind, how do we now view the AT1 sector? There are a number of ‘bond tourists’ in the high-yield sector, and this also applies equally, if not more so, to the AT1 sector.

Although this is a new product, the high yields being offered have certainly proved appealing to investors fishing for more attractive returns, so it comes as no surprise that some bonds ended up in the hands of fast money.

The recent underperformance of the bonds would have resulted in a lot of these short-term investors exiting their positions, although earlier this month there was evidence of real longer-term money buyers back in the market looking to pick up relative value on offers on the dips.

During this period of weakness it should also be mentioned that we had just one negative news story specifically related to AT1 bonds. That was when the FCA announced the banning of the sale of AT1s to retail investors. But with a typical minimum purchase size of £200,000, AT1s were already out of the realms of many retail investors and wealth managers have not generally targeted these bonds for their clients. So while we view this as an interesting story, it is not market moving.

While AT1s have been issued in significant size and have now experienced a relatively large retracement in prices, that doesn’t mean that large volumes of bonds are now on offer in the market.

Instead, the feeling is that traders are holding as few AT1s as they are holding high-yield bonds.

If the current geopolitical stories abate and this weakness proves to be a bump in the road rather than the start of something more sinister, the rally back to the highs could be every bit as quick as the sell-off we’ve just experienced. For those that missed the rally in Q1 2014, now might be the chance to revisit the sector.

Eoin Walsh is a founding partner and portfolio manager at TwentyFour Asset Management