Banks’ early pre-funding reduces AT1 extension risk

Over the last few months in the Additional Tier 1 (AT1) market we have seen a growing trend of issuers “pre-funding” their transactions even earlier. In some cases, such as Belgium’s KBC and Austria’s Erste Bank, bonds with expected call dates in 2025 have been tendered and replaced with new issues over a year early.

On the surface, this development makes perfect sense. AT1 spreads have compressed along with the rest of the market and issuers are capitalising on these strong conditions to get their deals done; we estimate year-to-date issuance is just shy of €40bn, roughly double the average for the same period over the last four years. That said, we would argue that pre-funding a perpetual instrument this far in advance is not necessarily common outside of Europe, and it could have broader implications for extension risk and volatility in AT1s.

As we highlight in our AT1 explainer, extension risk – when an issuer chooses not to call the bonds at the end of their non-call period – is one of the main risks investors should be aware of in this asset class. We see the impact of this more acutely during periods of market weakness (such as the period around the collapse of Credit Suisse in early 2023) when investors reassess their expectations around issuers’ willingness to call their bonds and the market often begins to price AT1s to perpetuity rather than their expected call dates. The steep price decreases we can see in such periods do not necessarily reflect expected losses on the bonds, which would be more associated with the risk of coupon suspension or principal write-down. Rather, the market reaction is pricing in a greater risk that bonds will be outstanding for longer (or theoretically forever) in a higher spread environment, with investors receiving inadequate compensation for the risk they have assumed.

As the chart below shows, since the inception of the AT1 product in 2013, periods of weakness in this market have tended to be sharp but rather short-lived; before the Credit Suisse crisis, other examples included concerns around AT1 coupon suspension at Deutsche Bank (which never came to pass) and the Covid-19 sell-off. The few extension events we have seen in the AT1 market thus far have often happened because the timing of the call coincided with one of these periods of acute volatility, or shortly thereafter.

More proactive pre-funding is therefore a sensible strategy for many issuers, as it makes them better able to navigate periods when the market may not be accessible; those that pre-fund well in advance will be able to stay away from the market and await better conditions. From an investor’s perspective, AT1 deals being pre-funded earlier provides more certainty around getting their capital repaid as opposed to finding themselves extended during one of those periods of market closure.

In addition to reducing extension risk, we believe pre-funding may also help to reduce volatility in the AT1 asset class. Indeed, if banks that pre-fund early are not compelled to come to market in periods when spreads are elevated, the muted supply picture should mean investor demand is directed towards providing a bid for outstanding bonds.

In our view, absent a more fundamental shift in the global macro environment (or at the very least the European macro environment) that would bring us into a protracted higher spread environment, extension risk in AT1s is being effectively addressed by proactive pre-funding from issuers. This is a significant difference to the US preference shares market, where pre-funding windows tend to be shorter as issuers routinely extend the bonds beyond their first call date, leading to greater uncertainty around their redemption.

Looking ahead to 2025, we estimate that about a quarter of AT1 deals callable next year have already been pre-funded. This level of pre-funding should give investors comfort that extension risk is being managed effectively by issuers, as well as potentially reducing volatility in the asset class at times of broader market stress.