How AT1s Can Help Boost a Bond Portfolio

Since their inception in 2013, Additional Tier 1 (AT1) bonds have developed into a $250bn multi-currency asset class that, with a high level of due diligence, can offer an attractive opportunity for fixed income investors facing another decade of ultra-low yields. With the unprecedented stimulus unleashed by central banks in response to the COVID-19 pandemic, it looks like investors will again be challenged by income becoming an ever scarce commodity. As such we think AT1s could be an interesting allocation consideration for all those bond investors looking to boost their portfolio yield.

Why AT1s now?

1. AT1s currently offer some of the highest yielding opportunities in the global bond universe. Yields on European bank AT1s can vary significantly depending on the size, geography and perceived quality of the institution, as well as the structure of the AT1 bond itself. The yield range in this diverse sub-sector is typically between 2.5% and 8%, and can offer attractive opportunities compared to other credit sectors; compared to the yields on high yield corporate bonds of the same rating, we often see a premium and relative value opportunity here.
2. The fundamentals look strong. In recent years investors have, in our view correctly, been wary of European banks’ equity story; the sector has been subdued by low interest rates and left behind by often more profitable US rivals. However, for bondholders we believe the picture looks far healthier. With most having withdrawn from riskier activities and issued billions of dollars’ worth of regulatory capital, European bank balance sheets now look to be more robust than they have ever been, with the average CET1 ratio across the sector now more than triple what it was a decade ago. The favourable comparison with unregulated high yield sectors of the market are obvious in our view.
3. AT1s have proven their resilience in 2020. While regulators quickly moved to restrict bank dividends and share buybacks as the economic chaos wrought by COVID-19 became clear in March, contractual AT1 coupons have continued to be paid. This reduction in distributions effectively added to banks’ retained earnings and has helped to enhance their CET1 ratios, thereby increasing the protection for holders of subordinated bank bonds such as AT1s.
4. The complexity premium. As a relatively novel product AT1s initially had to fight investor scepticism as, on the face of it, they presented a number of risks for bondholders. The bonds can be converted to equity or written down in full, and theoretically this can happen before CET1 trigger levels are hit if the bank’s national regulator deems the institution has reached its ‘Point of Non-Viability’. However, if you do the work to get comfortable with the true level of these risks (or rather you have a fund manager who does) then this ‘complexity premium’ can be seen as an added opportunity.

We appreciate why there continues to be a degree of perceived complexity premium associated with AT1 bonds, and in our view investing in the sector certainly requires extensive due diligence on the individual bonds, particularly around the optionality of the call structure for the issuer. However, we ultimately believe AT1 is an asset class that is largely under-utilised by bond investors, particularly those in the US who understandably are drawn towards the preference shares of their own strong domestic institutions.