European Banks' Dividends Suspended – are the AT1 Coco Coupons at risk?

UK banks shares slumped today (1 April 2020), after they cancelled their dividends and share buybacks and said there would be no payments in 2020. They took this action in response to a request by the Prudential Regulation Authority (PRA) of the Bank of England according to the media reports (e.g. Bloomberg, 1 April 2020). To be sure, this was hardly a surprise given that the continental European peers received a similar request from the ECB last Friday (27 March 2020). But for credit investors, the key question is what happens to the next layer of the banks’ capital stack – the Additional Tier 1 (AT1) contingent convertibles (Cocos)? 

As a reminder, the main attraction of the AT1 asset class is the high coupons that these securities pay in comparison to most alternatives. It is worth noting, that these have progressively compressed lower during 2019 and early 2020 deals in response to high demand for this asset class, prior to the market reversal. In short, AT1 investors get compensated for three risks: (1) coupon cancellation risk; (2) extension risk and (3) going concern loss absorption risk. And it is the coupon cancellation risk that is perhaps the most salient in current circumstances. 

With some very rare exceptions, the coupon on AT1 securities issued by European banks is fully discretionary and non-cumulative. In other words a bank can skip the payment of an AT1 coupon and this would not be an event of default, nor do bondholders have any legal means to force it to make a payment. As mentioned earlier, this is one of the reasons why AT1s have substantially higher yield than senior or Tier 2 bank debt. But it is not so simple. 

Walter Bagehot perhaps the most famous former editor of The Economist magazine once observed that “Every banker knows that if he has to prove he is worthy of credit, in fact his credit is gone.” This insight is very relevant as while skipping coupon on AT1 is legally possible it may come at a cost which is much in excess of the amount of the coupon itself – it may lead the market to question the very fundamentals of a bank. 

The media will have a very hard time to resist printing sensational headlines such as “[Pick a name] bank may be unable to pay interest on their bonds”. We have seen these sorts of headlines when the AT1 asset class was coming through its first big test in the Q1 2016. But this type of headline is highly deceiving because it questions the financial stability of the bank, even though it has every legal right to skip AT1 coupon payments. If a bank is unable to pay interest on any other bonds than AT1 – this is clearly a cause for major concern. And herein lies the crux of my argument – seeing a sensational headline such as the one above, how will the investors react? 

Will they (1) React calmly and research what kind of bond is in question here (e.g. AT1) and what is the reason behind the coupon suspension (perhaps due to regulatory intervention)? Or (2) Run for the exits by withdrawing any funds / exposure from the issuing bank without knowing the full story? Call me a cynic but I think most will be in the second category – the type of reaction that has the potential to spark a vicious feedback loop.  

In conclusion let’s start with some numbers. The current size of the European banks AT1 universe is (depending on the exchange rate) between EUR180-200bn equivalent. While the coupons vary quite a bit, for simplicity’s sake let’s assume the average is 6%. This then translates to potential annual savings of EUR10-12bn should all the banks suspend coupon payment. Even if the figure were somewhat higher, it is puny in comparison with the trillions of EUR equivalent when adding up various stimulus packages announced by Germany, France, Italy, Spain and the UK (and the list goes on). Simply put the cost of reversing the potential negative feedback loop by skipping AT1 coupons would I believe be well in excess of the amount saved. If my logic is right it then follows that weakness in the AT1 market may in fact be an opportunity to add exposure.