News Analysis: AT1s rumpus rumbles on

Issuing additional Tier 1 bonds, or AT1s, had previously been touted by regulators as a prime method for banks to meet new capital requirements.

The bonds themselves are contingent convertibles (CoCos) and caught investors’ eyes with a novel structure that permits them to be fully written down, or converted into equity, in the event of a bank undergoing financial stress.

But after several years of investors – including many bond fund managers – enjoying healthy yields from such securities, the asset class has now become the focus of a three-way dispute between banks, investors and European regulators.

Banks and investors took unkindly to European rules that, contrary to initial requirements, suggested coupon payments on AT1s must be turned off when banks fall below a capital ratio trigger.

The Deutsche experience reminded the market that the AT1 is just another complex financial product, with all the negatives that term inspires Gregory Turnbull-Schwartz, Kames Capital

The European Central Bank (ECB) made moves to provide more clarity on the instruments – bringing regulations in line with UK and Swiss markets, where banks have flexibility to protect AT1 holders over shareholders.

But according to TwentyFour Asset Management chief executive Mark Holman, other uncertainties continue to dog the market. In an immature asset class, events such as refinancing calls remain unknown scenarios, for example.

Deutsche Bank co-chief executive John Cryan renewed concerns in March when he described the bonds as a “bad product”, suggesting the bank had not wanted to issue such debt and would no longer do so.

The bonds themselves are still heralded by many as useful, highly beta-driven assets. But, while most fixed income products can boast returns year-to-date, the BAML Contingent Capital index, which encompasses AT1s alongside traditional convertibles, is down 1.6 per cent. European corporate debt indices are up more than 3 per cent.

Nicolas Trindade, a global bond manager at Axa Investment Managers, does hold the products but describes them as market driven and highly volatile.

“The primary market tends to open and close very quickly depending on what is happening elsewhere. At the beginning of the year, we had very little issuance because the market started on the wrong foot.

“In mid-February we saw more, and there is more to come because banks need to fill up their capital buffers.”

TwentyFour was one firm active in the new issuance market soon after the Deutsche Bank scare. Both it and Axa IM remain unconcerned about the potential fallout from Mr Cryan’s comments.

Mr Holman says: “Having shot himself in the foot by saying Deutsche Bank would pay its coupon, when we all thought it would anyway, his [recent] comments have been helpful.”

This, Mr Holman says, is because the words of caution should help keep risky issuance in check. He adds AT1s should be issued with yields at least 3 percentage points lower than a bank’s return on equity (RoE).

The fixed income manager believes banks will only be able to achieve an RoE of around 10 per cent. That is lower than many financials’ estimates of around 15 per cent, and would mean current AT1 yields of 9 per cent will, ultimately, prove too expensive for banks.

“When [Spanish bank] Bankinter came to the market, it only issued half of what it could, because it was expensive [for the bank to finance]. That’s healthy. And that’s what Mr Cryan is saying.

“He needs to be really certain what AT1s do for Deutsche Bank and what they mean to the market. He has seen how a negative reaction on AT1s can have a negative reaction on the overall cost of funding.”

This last point is one that has concerned other investors. Kames Capital investment manager Gregory Turnbull-Schwartz says AT1s are too small to ever truly aid a bank in times of stress.

He questions, therefore, whether their wobbles should have cast a shadow over all bank debt.

“The Deutsche experience reminded the market that the AT1 is just another complex financial product, with all the negatives that term inspires,” the manager said.

“Regulators described AT1s as the ‘canary in the coal mine’. The analogy is flawed. The doomed canary dies, but it doesn’t blow up the mine.”

Mr Holman remains unperturbed, and says he still expects up to $50bn (£35bn) of issuance this year.

“They still yield more than high-yield securities and 90 per cent of negative surprises come in the high-yield corporate market. We are talking about major banks that are very well capitalised.”