A Two Tier Market in AT1?

All banks’ highest quality capital is supposed to be permanent or perpetual. However, many bank regulators around the world allow banks to issue Additional Tier 1 Capital, colloquially known as ‘Coco’ bonds, as part of this capital base. These bonds are perpetual, but the bank has the option to call them after a specified period, typically five, seven or 10 years. These securities therefore tend to trade to the call date, and not to perpetuity, as investors rightly or wrongly assume that the banks will probably call and refinance these securities. The banks are under no obligation to do this, and some have said that that they would only do so if it was in their economic interest come the call date.

The AT1 market only opened in 2013, but by 2014 there was heavy issuance, with five-year calls being the most popular, meaning 2019 will reveal how many banks intend to treat their AT1 investors.

The first of the 2019 calls was announced yesterday by Spain’s BBVA on its €1.5bn 7% AT1. There was a little sweating by the market, given that BBVA waited until the very end of the call notice period, but they had already shown their intentions in 2018 when they called some of their 2013 issues and refinanced with new AT1 bonds. BBVA has managed its capital stack very well, as well as maintaining a healthy level of common equity. Had BBVA not called the 7% issue, the bond would have reverted to a coupon equivalent to five-year Euro swaps +615bp. Investors in BBVA debt can feel more confident that the bank’s securities will behave how they expect them to.

Those banks that actively manage capital and maintain sufficient capital buffers give themselves a high degree of flexibility when it comes to calling their AT1 deals. This in turn gives the bank an opportunity to place new issues at attractive levels, as investors will be more inclined to support tighter spreads in return for greater clarity on the redemption date (rather than run the gauntlet of extension risk to perpetuity).

On the flipside though, we think there will be banks that take a more short term, opportunistic view around the economic viability of the call. We think Santander is an institution that could fall into this category; they have €1.5bn of 6.25% bonds with a call on March 12, which if not called will revert to five-year swaps +541bp. If these bonds are not called, holders will be invested in longer duration debt than they may have expected it to be, and there must be a premium for this. Investors would have to think very carefully about any future new issue from institutions who take this economic view, particularly when the coupon is equivalent to current market levels or lower.

Consequently, we think that over time the actions of a bank, regarding the way they manage the callability, will ultimately create a two-tier market in the AT1 space. Those that are considered proactive in refinancing will sit in one tier, and those that are considered to be purely looking at the immediate economic viability will sit in another. Our view is that over time the broader implications of being serial refinancers will turn out to be economically beneficial for such issuers over the longer term.

The 2019 calls come at an interesting time for banks and their investors, as the banks are enjoying very strong earnings and robust capital positions, so the decision to call is entirely their decision. Naturally, if the economic environment was very different and banks were experiencing capital contraction, high loan losses and a poor economic environment, where the cost of fresh capital was prohibitively high, we would expect decisions to be far more pragmatic; as investors we would probably expect these AT1 bonds to extend, unless the bank had managed its capital particularly well.

The next callable AT1 is the bond from Santander mentioned above, but after that comes KBC, which can call its 5.625% €1.4bn issue on March 19. Even though the reversionary rate is just five-year swaps +476 bp, we see KBC taking the same view as BBVA with respect to their AT1 investors, joining the tier of prudent borrowers.