Two Key Questions as AT1 Reopens

Thursday saw the reopening of the bond market for bank Additional Tier 1 (AT1) debt, more colloquially known as ‘Coco’ bonds.

Until now, there had been no Coco issuance since the beginning of the market turmoil in March for three main reasons. First, banks have been in their reporting periods, during which they cannot issue new debt. Second, spread widening has rendered the cost of issuance unattractive to banks over the last two months. And third, there has been a degree of uncertainty over investor demand.

During the global financial crisis, the issuance of deeply subordinated bank debt was just not possible, but this time is proving to be different for the sector. While it is likely to be a challenging year for the banks, for us they do tick the boxes of being resilient and having visible earnings ahead of them, despite the unknown quantum of credit losses they will incur while the recession lasts.

Today’s icebreaker came from Bank of Ireland, not widely regarded as one of the strongest banks given the market in which it operates, but a resilient one nevertheless. The new issue was launched with the purpose of redeeming an existing security whose first call date is in June, effectively replacing the existing 7.375% bond with a new 7.5% bond, again with a five-year non-call period; so a small incremental cost to the borrower in terms of coupon, but also in transaction charges.

The new deal was effectively ‘reverse enquired’ by investors and the lead managers, making it a virtually riskless transaction for the borrower and the arrangers in terms of investor demand; a sensible way to operate with the most sensitive part of a bank’s capital structure in these times. So we can assume everyone is happy, except perhaps any investment banks who feel they missed out on this landmark piece of business, and any investors who didn’t receive their desired allocation.

However, this does gives us the opportunity to address two of the most frequent questions we hear from investors about AT1, a sector that is not yet a decade old and is now going through its first real set of challenges.

The first of these questions concerns callability. Do we think that banks will continue to call their AT1 bonds at the first call date, and if not, what is the extension risk?

We think most banks recognise they are typically paying a five-year price (or however long until the first call date) for perpetual subordinated debt, they respect this and will do their best to pre-finance their upcoming maturities. Bank of Ireland was perhaps a little unlucky, having left its pre-financing a little late in an effort to avoid paying two sets of coupons while the old deal was still outstanding, with COVID-19 hitting before it could come to the market.

If refinancing an existing transaction means banks paying a bit more to investors, again we think most banks are prepared to pay up to maintain this investor trust. However, they will not and should not pay any price for this; in the majority of cases the bonds are frequently callable, thereby allowing the issuers to wait until the next coupon date in order to achieve better pricing and a lower coupon, which we would argue is in everyone’s interest in the longer term. For banks with just one security issued in this sector, this is even more important.

We must therefore look at each case on merit and model accordingly, but in general we see the surprises going forward coming from banks that do call and pay up more than we expect, rather than those who don’t call and wait. Investment banks have teams of people to work on these refinancing trades, and they are all highly motivated to make them happen. As we can see in the case of Bank of Ireland, the cost of doing so is perhaps less than you might think. So good job to all the banks involved in this trasaction and to Bank of Ireland for working in such a tight timeframe and respecting its investors.

The second question is about AT1 coupons. Do we think regulators will ask the banks to turn these off, as they have done with dividends?

The answer here is quite simply no. There is a clearly defined regulatory framework that determines a bank’s health and its ability to meet these coupon payments. It is only when a bank’s capital falls through this capital floor that a coupon should not be paid. This is not connected to a bank making a profit or not. When we talk about resilience in this sector we are looking for the additional buffer of capital that each bank has over and above this minimum floor, above which coupons can be paid.

Meanwhile, if you do have further questions on this most interesting of sectors, then do please ask us.