When European banks first began selling additional tier ones (AT1s) in 2013 and 2014, analysts were confident that the asset class would eventually grow to a size of $200bn.
It was a simple prediction, mostly based on the fact that EU rules would only allow institutions to use AT1s as regulatory capital for a value equivalent to 1.5% of their stocks of risk-weighted assets.
Fast forward six years and the analysts have been proven almost exactly correct. The market is on the verge of reaching a steady state, with figures from CreditSights showing that there is about $200bn equivalent of capital outstanding from 221 different bonds.
Banks are entering a new phase, where, having built their AT1 capital layers, they will have to start thinking carefully about how best to manage and control them.
“When we get into 2020 it does feel as though the AT1 market will move into replacement issuance mode, where most banks have a 1.5% bucket plus a buffer,” says Peter Mason, head of debt capital markets EMEA at Barclays in London.
“Really they will just be refinancing calls as they come up, subject to regulatory sign off and the refinancing making economic sense.”
This shift was already beginning to take hold in 2019, when banks rolled over about €14bn of AT1 instruments into new securities.
But the whole process will hit top gear between 2020 and 2022, with an average of €21.7bn of debt coming up for call each year.
The Sintra surge
As banks prepare to embark on the first cycle of AT1 refinancing, they can feel confident that new issuance conditions are likely to work in their favour.
Following a few bumpy patches in late 2018 and early 2019, yields in the asset class have once again started falling — encroaching on record lows.
For Sook Leen Seah, head of capital advisory, debt capital markets at Nomura in London, a speech in June by former European Central Bank president Mario Draghi was a “pivotal moment” for market conditions in 2019.
Speaking in Sintra, Portugal, Draghi steered the market to expect the ECB to drop its deposit rate further into negative territory and restart quantitative easing — moves the central bank eventually made in September.
“The speech led us towards the expectation of even lower rates and it drove up demand for subordinated product,” Seah explains. “There was a lot of volatility in the market [in 2018], when it looked as though interest rates might be on the rise again. Now we are in a completely different scenario.”
As AT1 yields have come crashing down, most of the buy-side for bank capital has moved to expect that issuers will be able to call their outstanding securities and replace them at lower costs in the market.
The alternative would be for financial institutions to leave their AT1s — perpetual in maturity — outstanding beyond their first call dates.
In these instances the bonds revert to offering investors what is known as a “reset spread”, fixed at the point of issuance and paid over prevailing mid-swap or treasury rates.
“Banks have issued tier ones at some incredibly tight levels over the last few years, and we wondered at the time if many of them would ever be refinanced,” says Seah. “With the interest rate environment that we have now, you would have to say that banks are going to be able to replace these bonds with even cheaper instruments.”
Learning from Santander
Market participants have already had a taste of what it is like to see a bank extending the life one of its AT1s, after Banco Santander became the first bank to miss a call date in the asset class in 2019
It said on February 12 that it would not be repurchasing its €1.5bn 6.25% notes at the first opportunity the following month.
The move stunned some investors, mainly because the Spanish issuer appeared to have refinanced the securities when it sold $1.2bn of AT1 capital in the dollar market on February 6.
But pricing in the asset class was barely impacted by the bank’s non-call decision, and market participants were very quick to move on from the episode.
“The market has been clear in discounting Santander,” says Filippo Alloatti, a senior credit analyst at Hermes Investment Management in London.
Alloatti nonetheless warns against assuming that the market will remain immune to the risk of issuers extending the lives of their securities.
Deutsche Bank is an obvious candidate to succeed Santander in missing a call on one of its AT1 securities.
At the beginning of November, its $1.25bn 6.25% AT1 was yielding 36.5% to its first call date in April 2020 — a clear indication that investors think the German issuer would be best served by leaving the bond outstanding with a reset spread of 435.8bp over five year US Treasuries.
And there could be plenty of other situations in the coming years where banks find themselves in a position where it is not economic for them to replace an old deal with a new one.
“It would be a little too complacent to say that the market will not reassess the likelihood of AT1 calls when another issuer decides against calling — some bonds that are artificially too high may come down in price,” says Alloatti.
Flexibility for nothing, puts for free
For now though, European financial institutions appear to be dead set on replacing their AT1s, often as quickly as they possibly can.
In certain cases, issuers are acting up to a year in advance of a call date to bolster their capital positions.
BBVA sold a €1bn 6% AT1 in March, for example, with one eye on what it might end up doing with its €1.5bn 6.75% deal, callable in February 2020.
It is not hard to see why banks are getting itchy feet. As the riskiest form of debt on their balance sheets, AT1s are highly exposed to bouts of volatility.
Several instances of rough market conditions have proven in recent years that, when misfortune does strike, the correction can be quick and brutal for the asset class, shutting issuers out of the market or forcing them to pay up considerably.
With this in mind, some banks have embarked on a spot of future-proofing when selling new AT1s in 2019.
An increasingly popular technique, borrowed from the corporate bond market, is for issuers to include an option in their deals that gives them six months to call at par in the run-up to the first reset date.
The feature means that banks can have more control in deciding if and when they want to refinance their AT1s.
It could also limit the practice of doubling up on interest payments, which is rife at the moment as institutions jump into the market early, months ahead of call opportunities.
“The six month par call will become a market standard pretty quickly, if regulators allow,” says Mason at Barclays. “The acceptance of these structural features all comes down to market conditions and the constant tug of war between investors and issuers.
“For most of this year it feels as though issuers have had very favourable market conditions and have won out on most of these structural points around AT1 issuance.”
The UK’s Nationwide Building Society was the first financial institution to introduce investors to the six month par call in an AT1, when it used the option as part of a £600m deal in September.
It was quickly followed by the likes of AIB Group in Ireland and La Banque Postale in France.
Alloatti notes that, by and large, these issuers have not been paying any “premium” to include the new feature in their AT1s.
“That’s a reflection of how the market has been,” he says. “Bondholders are to some extent writing a put option to issuers, and this put option is coming for free. It makes sense for issuers to be exploiting this.”
Towards a new low
Banks have really taken the driving seat in the AT1 market, just as they have ceased to rely on investors to bulk out their total capital ratios.
In recent months, amid a global hunt for yield, they have been pushing funds towards their limits in terms of pricing on new securities.
Norway’s DNB Bank beat the record for the lowest ever coupon for a benchmark AT1 bond in the dollar market in November, for example, smashing through 5% to price an $850m deal at 4.875%.
Earlier in the year Rabobank claimed the same prize in the euro market, raising €1.25bn of perpetual non-call 7.25 year capital at a coupon rate of just 3.25%. Market participants suggest the trend is yet to run its course.
Stellar returns for bank capital funds have helped to attract a mass of new inflows from investors this year. And the monetary policy of the ECB is continuing to drive accounts in search of better returns — something that AT1 securities can still claim to offer.
With the size of the market having pretty much levelled out in 2019, any new demand for the asset class is unlikely to be matched with net new supply. This can only have one impact on the direction of yields.
“The average coupon for an AT1 is probably 5%-6%, which means the market has something like €10bn of coupon payments per year,” explains Axel Finsterbusch, an executive director in European credit research at JP Morgan in London.
“The fact that the AT1 asset class is not growing any more should be supportive for valuations,” he says. “It should be supportive for valuations, without a doubt.”