AT1s: Why bondholder expectations matter

Bondholder expectations are an important topic in the Additional Tier 1 (AT1) market.

One of the key concepts involved in AT1s is that investors generally expect to have their coupons paid and for the bonds to be called at their first call date. Bondholder expectations are often perceived as a “soft” factor that is hard to quantify, and may often appear at odds with the purely economic considerations of the issuer when it comes to refinancing costs.

Here we will explain why bondholder expectations are a key consideration for banks, and describe how they feed into the call decisions banks make around AT1s, which we believe should never be based on the strict refinancing cost of the deal alone. It is worth stating that while we are addressing bondholder expectations in the context of AT1s, the principle applies to all forms of debt as a bank’s treatment of its creditors can have implications across the whole of its debt stack.

For banks, both equity and bond investor expectations matter

Equity investors have certain expectations around how profitably a bank deploys their capital; if a bank doesn’t maintain a healthy return on equity (RoE), it may struggle to issue new equity in size when needed, which is an important tool for a leveraged institution that is always more or less vulnerable to unexpected shocks.

But while shareholder expectations certainly matter, generally speaking a bank can survive longer without equity market access than it can without bond market access. Banks are inherently highly leveraged due to the nature of their business model. Combine that balance sheet position with ongoing funding and regulatory requirements, and a lack of access to debt (be it deposits, senior unsecured bonds or AT1s) can quickly become terminal for banks.

In this context, we would argue that for any bank, management of debt or bondholders’ expectations is as important, if not more important than the expectations of shareholders.

Some banks need to prioritise debt over equity investors

The balance of prioritising debt or equity investors is not a one-size-fits-all, given the diversity of the European banking sector. There will always be some banks in a position where they need to prioritise the expectations of bondholders over shareholders – if not indefinitely, then at least in the short-term. These include banks that are undergoing a restructuring or delivering returns lower than peers, and cooperative or other banks with no clear access to equity markets. Nearly all banks also need to consider their ongoing reliance on bondholders to support ongoing regulatory debt requirements.

In terms of the first category, we would argue that banks undergoing restructuring or delivering sub-par equity returns are living on borrowed time (literally and figuratively). The length of that time may be determined by the speed or success of the turnaround, or the degree to which credit conditions are supportive and creditors are willing to fund the ongoing restructuring. These institutions can normally be identified by elevated funding costs or credit default swap (CDS) levels versus peers (more on this later). For banks that have no access to equity markets, clearly bondholders’ interests need to take priority.

It is worth noting here that the conduct of individual banks will not be looked at in isolation by the investor base – peer pressure matters. A bank may well be delivering good return on equity for its shareholders, but its treatment of bondholders will still be viewed against others operating in the same European banking environment, including those such as cooperative banks that are arguably better able to prioritise bondholder expectations. 

Meeting bondholder expectations does not guarantee survival, but it does increase your chances

Bank creditor expectations come in all shapes and sizes. Depositors expect to have immediate access to their cash. Senior unsecured bondholders may want institutions to maintain certain ratings. Subordinated debt investors may expect to receive the discretionary coupons on their bonds and have them refinanced at their first call date, within reason. In addition, all groups may expect certain financial incentives, like a one-off compensation for moving deposits to the bank or a new issue premium when investing in a new bond deal.

These expectations often form an important element of the investment thesis in debt instruments (as they do for many in AT1s), and when they are not met, investors may reassess the suitability of the debt instruments or issuers they invest in.

Importantly, meeting these expectations is no guarantee of survival for the bank. If the fundamental situation deteriorates beyond what the market sees as the point of no return, it is perfectly rational for debt investors to depart, since they have little prospect of upside in a recovery situation (think of Credit Suisse or Metro Bank in 2023).

However, meeting bondholders’ expectations can conceivably broaden a bank’s investor base, persuade existing investors to increase their allocations, or help bondholders have a higher “pain threshold” if the bank’s situation does deteriorate in a less supportive environment. Conversely, failing to meet expectations can alienate investors, lead to reduced allocations and prompt investors to depart at the first sign of problems. All else equal, disappointing bondholder expectations increases funding costs for any bank.

Funding costs are a key competitive advantage for banks

A typical bank balance sheet is relatively straightforward. Banks hold low margin assets such as mortgages and loans and rely almost exclusively on some form of debt funding. As the asset side of the balance sheet is homogenous (mortgages and loans are standard products at every bank), the main differentiating factor from an investor perspective is the bank’s cost of liabilities. Indeed, banks that can fund their activities more cheaply than peers will have a competitive advantage.

High funding costs can be problematic for all sorts of reasons. For globally connected banks, an elevated CDS spread (a widely-used proxy for default risk) may indicate heightened counterparty risk and limit the number of clients willing to engage with the institution.

For all banks, their cost of funding has a direct impact on the viability and profitability of various lending activities, whether that is existing or new business. In other words, banks with higher funding costs will not be able to stay competitive on the lending front and over time will see their balance sheet shrinking. This shrinkage cannot go on forever, as the bank has to maintain a certain level of revenue to support its current cost base (profitability at this point tends to be too low to engineer restructuring, while access to equity markets may be cut off). It is important to note here that banks cannot simply originate more loans for the sake of higher volumes; the associated capital requirements would grow too fast compared to the underlying profitability and the bank’s capital buffers would be eroded.

Given the importance of funding costs, meeting bondholders’ expectations can help to improve a bank’s competitive advantage versus peers (especially for those institutions that rely heavily on the bond markets).

The relevance of subordinated bondholders

Equity may only represent a small portion of the liability side of a bank’s balance sheet, but subordinated debtholders typically represent an even smaller portion, though this can vary widely depending on the market capitalisation of the institution. Banks that are under stress tend to have a lower market capitalisation relative to their outstanding subordinated debt. As an example, Deutsche Bank’s outstanding AT1 and Tier 2  bonds currently stand at around €20bn versus its market capitalisation of around €45bn, but back in March 2020 when DB’s market capitalisation fell to around €10bn, subordinated bondholders represented more than double the bank’s market capitalisation. Clearly, this can shift priorities quickly.

As we already indicated, the subordinated creditors in European banks generally expect (i) to receive coupons on bonds where payments are discretionary (as they are for AT1s), and (ii) to have their bonds called/refinanced at their first call date. The first expectation is obvious, but cannot be taken for granted considering AT1 issuers are able to suspend coupons at their own discretion, which for some banks at certain times could lead to meaningful cost savings. Redemption at the first opportunity is normally expected within reasonable market conditions, and this is driven in part by historical market convention. In the past, like corporates, banks were able to offer redemption incentives (e.g. coupon step-ups) in their callable debt instruments, though regulation now prohibits these.

These expectations are a central part of the investment thesis for many investors. It is instructive, for example, that since late 2022 when the Australian regulator told banks it expected them to make call decisions on the basis of refinancing cost alone, the banks have evidently pushed back; we have continued to see Australian banks call and refinance capital instruments at higher coupons than they would have been paying if they had not called (i.e. an “uneconomic” call for the bank if the decision is viewed in isolation). In other words, the principle of calling at the first call date is a deeply ingrained market convention, even when such regulatory recommendations are in place.

Following a situation where the issuer fails to meet expectations of subordinated bondholders, it should reasonably expect to see some investors potentially reducing allocations to that issuer and/or blacklisting the issuer altogether. This can be partly because the issuance may no longer fit the investment thesis of their specific mandate or fund. Indeed, a non-call in some cases can also be a signal of potential problems ahead. For example, Deutsche Pfandbriefbank failed to call its Tier 2 in May 2022 only to experience greater stress two years later – the issuer has still not accessed the market for Tier 2 debt since.

Issuers should also be mindful that spread widening in subordinated bonds is often replicated higher up the liability stack. This leads to a situation where a very small portion of disappointed subordinated bondholders can have a disproportionate impact on a bank’s broader funding costs and therefore the competitiveness of the entire institution. Often the costs of disappointing this small group of bondholders ultimately outweigh the economic benefit gained.

Bond investors tend to vote with their feet

In summary, we consider managing and meeting bondholders’ expectations to be of paramount importance for any bank given their inherent reliance on debt. Being “bondholder friendly” can take many different forms; it could be managing ratings, improving communication, offering consistent new issue premium, or calling bonds based on the market convention (within reason given the bank’s economic circumstances). Banks with high RoE or a lower reliance on debt markets may be in a better position to manage those expectations more aggressively and prioritise certain groups of creditors over others, while others as noted above should be more careful in breaking away from established norms. That might mean offering healthy new issue premiums, or more specifically in the case of AT1s, being less sensitive to the economic costs of a call which often represent a fraction of overall funding costs.

In both cases, the issuers that break away from established market norms, or confound expectations, should reasonably expect to enjoy a lower breadth and depth of investors willing to buy their instruments. All else equal, this translates to higher funding costs in the medium term, which will steadily exert pressure on a bank’s competitiveness versus peers.

For credit investors, beyond analysing the more important fundamentals of each individual issuer, we believe it is important to hold individual banks accountable for their conduct in the bond market. Bond investors are typically rather good at voting with their feet, even if sometimes it may appear they have short memories when market conditions are supportive for credit.

Important Information

The views expressed represent the opinions of TwentyFour as at 27 March 2025, they may change, and may also not be shared by other members of the Vontobel Group. The analysis is based on publicly available information as of the date above and is for informational purposes only and should not be construed as investment advice or a personal recommendation. 

Any projections, forecasts or estimates contained herein are based on a variety of estimates and assumptions. Market expectations and forward-looking statements are opinion, they are not guaranteed and are subject to change. There can be no assurance that estimates or assumptions regarding future financial performance of countries, markets and/or investments will prove accurate, and actual results may differ materially. The inclusion of projections or forecasts should not be regarded as an indication that TwentyFour or Vontobel considers the projections or forecasts to be reliable predictors of future events, and they should not be relied upon as such. We reserve the right to make changes and corrections to the information and opinions expressed herein at any time, without notice.