RT1s in vogue once again as issuance bounces back

NN Group, the Dutch insurer, has issued its inaugural €750m Restricted Tier 1 (RT1) deal, which came with a 6.375% coupon and BBB-/BBB rating from S&P/Fitch. The deal was four times oversubscribed with pricing tightening around 70 basis points from initial price talks. 

The transaction follows a €1.5bn RT1 from AXA launched in January this year (more than five times oversubscribed and similar price tightening) and brings year-to-date issuance to €2.25bn – well above the €400m equivalent in 2023 and €950m in 2022. The latest bond will take the total issued size in the RT1 space to €19bn. This implies RT1s remain a niche asset class – for some context, the total outstanding from Additional Tier 1s (AT1s) is closer to €190bn, while high yield sits at €1.64trn.

And with issuance and activity on the rise we thought it timely to explain what RT1s are, why the ratings are so high and what the benefits are of the asset class. 
 
So, what exactly are RT1s?
 
In short, RT1s are a sister product of AT1s, though they are issued by insurance firms in Europe rather than banks. RT1s represent the most junior form of hybrid debt issued by European insurers, with no stated maturity date, discretionary coupons and loss mechanism triggers linked to the issuers’ regulatory capital positions. Considering the inherently high standalone strength ratings of insurance firms, the RT1 universe differs from AT1s in one important aspect – around 90% of outstanding RT1s are rated investment grade by at least one rating agency. This figure stands closer to 60% for AT1s.

What is driving the high ratings of RT1s?
 
First and foremost, it is the standalone strength of the issuers in this space that underpins the ratings. In this context, we would note that most insurers in Europe carry solvency coverage ratios of well over 150% and many are in the 200% to 300% range – the minimum regulatory requirement is 100%. Not only are the solvency metrics well above the regulatory requirements, but the sensitivity of the capital ratios to various market developments (rates, spreads, equity prices, real estate valuations or rating downgrades) remains well managed and low. 

Furthermore, leverage in the insurance sector remains low – most of the large insurance groups operate with a maximum leverage target of 30% and many are under or around the 20% mark. This means that interest coverage is often well over five times. Finally, in terms of fundamentals, it is worth noting that most RT1 issuance has come from composite insurers. These firms benefit from well diversified business models and presence in life and non-life segments, which are usually well spread geographically, leading to reliance on multiple income streams. 

It is worth mentioning that we have not had any high-profile failures of insurance firms in Europe, even including during the global financial crisis and the period of Eurozone crisis that followed. Low rates put pressure on some business models – particularly those in Germany with a high proportion of guaranteed life insurance policies – but even then, insurance firms weathered that environment. The most recent increase in interest rates certainly provided a tailwind to European life insurers.

Away from fundamental considerations, it must be mentioned that RT1s benefit from more attractive notching considerations from the three main rating agencies. On average AT1s are generally rated anywhere from two to three notches lower than Tier 2 debt. The difference is one to two notches for RT1s and most recently Fitch proposed new methodology changes that in some instances will equalise the RT1 and T2 ratings.

Why does outstanding RT1 issuance remain small?
 
Firstly, total subordinated debt issuance from European insurance firms stands at around €175bn equivalent. This compares to around €500bn in hybrid debt from European banks, of which €187bn is AT1s. As a result, the RT1 space will naturally be smaller.

Secondly, European insurance regulators brought into effect a new rulebook (Solvency 2) only from 1 January 2016 and this established RT1s as a new hybrid instrument that insurers can count towards their solvency metrics. In anticipation of these rules, during 2014-15, European insurance firms took advantage of the transitional arrangements and issued cheaper perpetual Tier 2 debt that they were allowed to count as RT1 capital until end-2025. This transitional issuance has substantially slowed down the initial growth of RT1s but is slowly coming up for refinancing.
 
Indeed, the first benchmark RT1 was issued only by another Dutch insurer ASR in September 2017. RT1 issuance has only really picked up in 2020 and 2021 when European insurers brought €4bn and €5bn, respectively. By now, the total outstanding amount of RT1s stands at around €19bn. We expect this to grow as insurance firms still have around €20bn in old-style Tier 1 instruments, which will not count towards solvency ratios from 1 January 2026. The need to replace these old deals will drive issuance already in the coming months, in our view.

What sort of upside do we see?
 
As stated above, RT1s remain a niche asset class, which does not belong to a specific ETF index. Ninety per cent of the issues benefit from at least one investment grade rating and yields in the space are comparable to those offered in AT1s and above those in high yield. Considering the higher ratings, as well as the great track record of performance of this sector, we see the asset class as offering superior risk/reward versus high yield where the spreads have compressed considerably. As the growth of RT1s continues in the coming years, we also expect liquidity in these instruments to improve over time.