AT1s: Finding the risk/reward sweet spot

It’s been over a year since Credit Suisse; subordinated financials once again offer significant potential for credit experts with the tools to identify the right paper while riding the volatility.

AT1s, or CoCo bonds, are generally seen as volatile and high risk – a viewpoint only reinforced following the collapse of Credit Suisse in March 2023. Controversially, the bank’s AT1s dropped to zero despite the Tier-1 ratio being above the trigger point for the equitization of the AT1s in the structure.

Against this backdrop, it seems prudent to question what role these bonds can play in a fixed income portfolio today.

While there are certainly risks to buying any subordinated bond within a company’s capital structure – there is never a free lunch – some of the risks can and have been mitigated by careful selection of the issuer bank. When approached correctly, we’re currently seeing an interesting value proposition in the AT1 market, specifically in large, well-capitalised financial institutions.

Today’s economic environment is broadly supportive for banks – they are benefiting from higher interest rates on their loan books, complemented by a still-robust economic environment in Europe and the US. But the devil is always in the detail. Some banks have large distressed-loan books, others operate in less benign regulatory environments and some are exposed to regional pressures, such as the second-tier US banks with notable real estate exposure.

A nuanced selection is key; the coco market is certainly not the place for a broad-brush approach, but the right bonds coming out of the right banks look very interesting.

For us, the ‘national champion’ banks, which offer big equity cushions and robust business models, represent the risk/reward sweet spot. Coupons (if not spreads) are still very attractive, with recent coupons in the high single digits, and we think it makes sense to take exposure in the more subordinated bonds of these big, well-run organisations. The correlation to the high yield market is low, and whilst the AT1s are volatile, they offer good diversification and attractive potential returns within the bank bond sector.

Beyond these robust credentials, AT1s also offer a potentially interesting relative value opportunity – something that’s becoming more and more difficult to achieve in other sectors. Banks offer you the choice of low-coupon bonds with short calls, which require an assumption of whether the issuer bank can refinance at better rates within a short period. Or you could buy the higher-coupon, longer reset with higher duration from the same bank.?

Understanding supply technicals, as well as the history behind a bank’s decision to call or not, also offers opportunities to investors who have the tools to make those decisions.??

As credit experts, we are confident in digging out the value AT1s can offer and believe they can add a quality yield element to a global high yield book and more generally to a diversified bond fund.

Within our portfolios, we start with national champion banks that have the right fundamentals layered with a good funding mix (retail & wholesale), robust liquidity and good risk-management controls.

Against these bottom-up metrics, we also think it makes sense to include a macro view. For example, when the rate-rising cycle began, we knew that the one metric that had hurt banks was the net interest margin; finally, this measure of profit and growth would be improving after 10 years of stagnation.?Now on the cusp of rate cutting, we’re taking into account the fact that a more stimulatory economic environment should also be good for banks.

Overall, we think the asset class receives outsized focus due to its relative ‘newness’, alongside the inherent complexities of the different regulatory regimes investors must wade through, plus the unique language on each bond itself.

AT1s aren’t for everyone, but as credit experts, we think they have a lot of offer.

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