Issuer calls drive AT1 spread compression

A few weeks ago, JP Morgan skipped a call on one of its $1,000 par preference shares (“US Prefs”). The perpetual notes had a coupon of 6.75% payable until Jan’24, with a subsequent reset of 3-month SOFR + 404bps. Post the non-call, the coupon changed to 9.35% and will continue to reset every 3 months. The preference shares are callable quarterly, so any price appreciation will be limited. Market participants remain alert to any signs of weakness, and so the development prompted some confusion and questions around call economics, with the attention inevitably turning to Additional Tier 1s (“AT1s”) – the European equivalent of the US Prefs.

We are taking this opportunity to highlight the stark differences in call behaviour of these capital securities between US and European issuers. We note that since 2018 – when the first AT1s came up for a call – the six largest US banks have called nearly $40bn in US Prefs. Out of this number, only 32% were called exactly on the first call date. The remaining 68% were called anywhere from a few months to a few years after the initial call date passed. Outside of the called universe, we note there are currently $10bn of outstanding US Prefs that were not retired at the first opportunity.

The reasons for each non-call vary. These might have been due to (i) the timing of a new issue to replace the existing deals, (ii) call period falling around early 2020/start of Covid when the new issue market was closed, (iii) more recent uncertainty around the upcoming Basel 3 regulation and the expected increase in risk weighted assets, or (iv) simply because the reset on the existing bonds was sufficiently attractive to keep them outstanding beyond the first call date. In any event, one can conclude that whatever the underlying reason for a non-call, US banks continue to exhibit strictly economic behaviour in their decisions. Importantly, this is in line with investors’ expectations for US Prefs.

The European AT1 market has been the exact opposite of the US Prefs with respect to the calls. Indeed, we calculate that approx. €90bn in AT1s have so far come up to their first call date. Of this amount, we estimate that just under 7% (or about €6bn) was not called at the first opportunity. Furthermore, out of this amount only about EUR3bn still remains outstanding (as most are callable only every 5 years) with the other €3bn already called at subsequent redemption dates. In 2024, we still have €21bn equivalent of AT1s coming up to their first call date and we expect basically all these securities to be taken out.

At this point, we would emphasize that European issuers, much like US peers, continue to assess the economics of each AT1 call. We believe however that European banks (i) place greater importance on the AT1 market given generally lower European equity valuations vs US peers, and (ii) assign higher reputational risk to an AT1 non-call considering the behaviour of peers and the fact that market participants have been conditioned to expect these securities to be retired at the first call date – as per the data above.

We are indeed convinced that this call market convention (i) has shaped the way in which investors think about the product, (ii) made it more appealing to a broader audience, and (iii) medium term, along with the fundamental strength of the sector, will continue contributing to further compression of risk premia for this specific asset class vs other alternatives – a trend which we have seen since the onset of AT1s.