AT1s offer wider spreads than other similarly rated fixed-income investments at each point on the credit quality spectrum—from BBB down to B. And within financial credit, spreads between AT1 and Tier 2 debt have widened from a record low 146 basis points (b.p.) in February 2020 to 261 b.p. by the end of 2020. This leaves plenty of room for spread compression as the virus recedes and markets normalize, in our view.
What’s more, AT1s have also shown better risk/reward characteristics than bank equity during up and down markets (Display above, right). AT1s’ high and predictable coupon (currently 6.1% on average) has been much more supportive than bank stocks’ dividends. And AT1 prices are more influenced by banks’ capital strength, which has been improving, whilst stocks are highly geared to less reliable earnings.
Bank Capital Remains Key to Euro-Area Recovery
Trends that supported AT1s in recent years should persist through the recovery, in our view. Regulators are keen to ensure that the banking sector has adequate capital to sustain lending to euro-area businesses and underpin economic recovery. Countercyclical buffer requirements are also likely to remain low to help free up bank capital, promote lending and lower the minimum capital that banks must hold to pay the AT1 interest coupon. That requirement reduces the risk of missed payments (coupon skip) for investors.
Regulators also want to give banks more time to comply with new and more onerous capital requirements (TLAC/MREL), reducing pressure to issue senior or subordinated bonds. As a result, we expect AT1 net supply to remain low, as most banks already comply with current minimum regulatory standards. Meanwhile we think AT1s’ high yields are likely to attract increasing demand as the virus recedes and economies rebound.
Be Selective in AT1s
The AT1 market has rallied since March 2020 lows and some bonds’ valuations may be less appealing, especially since the volatility of those securities may be quite high, as they were in 2020. Thorough research can identify names that offer compelling risk/reward characteristics and pockets of unrecognized value. For example, select smaller banks may be merger or acquisition targets and could see their spreads compress in line with the stronger acquiring banks’ bonds. Some Spanish and Italian banks still offer good value, in our view, as do legacy Tier 1 issues, which are set to be called now that regulation has been clarified.
Bank bonds have benefited from a powerful tide through the pandemic. With many of the supporting trends still advancing, bondholders should keep faith in European banks.