AT1 bond yields almost at historic highs

05. Oktober 2023

The full write-down of Credit Suisse's AT1 bonds sent shockwaves through the market. However, its recovery was surprisingly quick and attractive investment opportunities are opening up for investors, says Daniel Björk.

Interview with Daniel Björk

"Profitability for large European banks is the highest we have seen in the last 15 years", says Daniel Björk, portfolio manager Swisscanto Bond Fund Responsible CoCo.

After the historic write-off of Credit Suisse's AT1 Cocos, the Coco market was pronounced dead. How has the global market developed since then?

Daniel Björk: The event triggered an abrupt sell-off in the AT1 market, similar to what we experienced in the first quarters of 2016 and 2020. However, the market rarely stays at such extreme levels for long, AT1 bond prices started to recover quickly also this time.

Euro CoCo Additional Tier1 Price Index Level (Source: J.P. Morgan)

Why that?

The fundamental strength of the Banking sector, combined with unusually high yield levels, typically draw new investor interest and help the market to quickly start its recovery path. The average credit spread on AT1 bonds has narrowed to a level where the market for new issues of AT1 bonds has reopened. Since June we have seen seven new AT1 issues with historically high coupons between 8 and 9.5%. In addition, eleven AT1 bonds have either been redeemed at first call date, repurchased by the issuer, or likely pre-financings of upcoming redemptions in in the first half of 2024.

If a bank does not call the AT1 bond on the first call date, this is "punished" with a discount on the bond price. What is the situation here?

The so-called extension risk has so far been significantly lower than expected. Since the beginning of the year, 13 AT1 bonds have been called at the first call date and only one AT1 bond of a global bank has been extended. However, the market currently assumes that only a quarter of all AT1 bonds will be redeemed at the first call date and that 75 per cent will be extended in return. In our view, the market is pricing in too much extension risk, which could indicate an interesting market opportunity.

How did the CS write-down affect yields? Have investors been demanding higher returns since then?

Yes, although the average credit spread on EUR AT1 bonds have come down from the dramatic levels above 700bps seen in March to the current 560bps, we believe this level is still attractive.

Euro CoCo Additional Tier1 Z-Spread to Worst (Source: J.P. Morgan)

So what are the yields on AT1 bonds?

The current yield on AT1 bonds in EUR is currently nine percent on average (as of 3 October 2023). This is close to historical highs. Only in October 2022 and for a few days in March 2023 were yields higher. It should be added that the profitability of large European banks is higher than it has been for 15 years and balance sheets are much stronger.

Euro CoCo Additional Tier1 Yield to Worst (Source: J.P. Morgan)

The higher the return, the higher the risk of loss - this also applies to AT1.

In my view it is crucial that investors are being compensated for the underlying risks. Given the historically high yields combined with solid fundamentals in terms of issuer profitability and solvency, AT1 bonds currently offer a good risk compensation.

What about the secondary market?

Secondary market liquidity has also been good with total trading volumes year-to-date actually 35% higher than for the same period last year. Contrary to popular belief, the secondary market has remained rather liquid even during difficult phases with many active trading partners.

How has issuance developed in recent months? And are there any geographical anomalies in terms of issuers?

Somewhat unusually, we have seen more new AT1 issuance in EUR than in USD. The AT1 market is skewed towards USD, with USD AT1s representing 60% of the market and EUR AT1s only 30%. However, since new issuance started in June, 60% of issuance has been in EUR with a total issuance volume of EUR 3.5bn. Only 40% of issuance has been in USD, with total issuance of USD 2.5bn. In contrast, we have seen very limited activity in GBP and CHF.

The main argument for buying shares in a Coco fund rather than investing in a single AT1 bond is diversification - what else?

Diversification is even more beneficial for smaller investors as the minimum denomination of AT1 bonds is the Swiss franc equivalent of around CHF 200,000 compared to a Coco fund with a minimum of CHF 10,000. Investing in a CoCo fund is also advantageous from a currency hedging perspective if a fund offers currency-hedged share classes in the desired currency. Importantly, by investing in a CoCo fund, the investor outsources all the work involved in monitoring regulatory developments, analysing and selecting individual banks and individual AT1 bonds, which can have a tangible impact on investment performance, as the alpha opportunity in the AT1 bond market has historically been significant.