Reform of the AT1 bond market

The AT1 bond market may be in need a reform to regain investors’ confidence, after rules were upended by the state-backed takeover of Credit Suisse by UBS earlier this year.

In March, the Swiss Financial Supervisory Authority (FINMA) ordered the complete write-down of AT1 bonds worth CHF16bn (€16.6bn), reverting the hierarchy that sees shareholders absorbing losses before AT1 holders if a bank runs into trouble.

The decision triggered a sharp sell-off of securities issued by European banks, with the European supervisory authorities rushing to clarify that FINMA’s order would not be followed in the European Banking Union.

“While the EU regulatory policymakers and supervisory authorities were comparably quick to call out Switzerland’s ’unique approach’ to AT1 waterfalls, further work for legislative clarity could be provided as part of the ongoing CMDI (EU’s bank crisis management and deposit insurance) framework package reforms,” Michael Huertas, head of the financial institutions regulatory Europe team at PwC Legal, told IPE.

He added: “It is conceivable that further supervisory guidance may be forthcoming regardless of any future legislative drafting as a result or in support of the CMDI package discussions.”

A number of changes to the rules and practices surrounding the AT1 bond market could help the asset class and propel valuations higher.

“One such example would be conferring full flexibility around calls of AT1 bonds to the issuer, as long as the capital requirements are being met. As things stand, extension risk represents the biggest question mark and the asset class is not only held back by uncertainty related to the issuers’ behavior, but also ambiguity with regards to the stance from the regulator,” Eoin Walsh, portfolio manager at TwentyFour Asset Management, told IPE.

Another potential change for Walsh relates to the issuance of new standardised capital instruments, with trigger levels closer to 7%. AT1 bonds are converted to equity or written down completely if the ratio of capital to risk-weighted assets falls below 7%.

Walsh added: “This would likely force some issuers to refinance existing AT1s on their first call date [where the bonds have a 5.125% trigger] but would further simplify the asset class, which in the long run should represent a positive catalyst for the valuations.”

Allianz’s head of external funding Achim Wiechert explained in an interview with Bloomberg in October that one of the most important features of AT1 bonds is that they do not have a maturity, meaning that banks are not required to pay back Tier 1 instruments and replace them with state aid – one of the main difficulties faced by the asset class during the 2008 financial crisis.

This unwritten rule means that banks repay the securities on the first possible call date, a de facto mandatory requirement, also when a bank goes through a crisis.

Wiechert is proposing, among other changes, to allow early calls depending on market developments. According to Bloomberg, Wiechert has presented his plan to reform the AT1 bond market to the European Central Bank, the European Banking Authority and the European Commission.

Not yet fully recovered

FINMA’s decision shook the market, with investors adopting a cautious approach, but the market has seen gradual recovery since then.

However, the rather arbitrary method in which Swiss authorities imposed losses on the AT1 instruments of Credit Suisse has held back the full recovery of the asset class, said Walsh, pointing to AT1s from Swiss issuers that have lagged the recovery of European peers.

In August, the volume of Swiss banks’ AT1 bonds was around CHF18bn. The largest issuer was UBS, with approximately CHF11bn, followed by Julius Baer, Zürcher Kantonalbank and Raiffeisen, with approximately CHF1bn each, according to a report by the Swiss group of experts on banking stability.

Last week UBS has started selling AT1 bonds for the first time since it took over Credit Suisse. These are first AT1 instruments with an equity-conversion feature in the event of a breach of a common equity tier 1 (CET1) ratio or if a “viability event” occurs as per the documentation, S&P said in a note.

“The key challenge is for investors to start believing once again that the authorities will respect bankruptcy waterfall losses in any loss scenario. We believe we do not need to see any significant or structural changes to the product, for the valuations to recover back to pre-credit Suisse levels, although clearly these would be positive for the asset class,” said Walsh.

It will take a few more months – and probably a few more calls – for the market to regain the confidence in the asset class that was apparent prior to the unprecedented Credit Suisse events, Walsh added.

For Huertas, market participants and supervisors will want to take a number of steps to shore up confidence in the market and the nature of these instruments, focusing mostly on increasing efforts on due diligence and the specific risks realted to each AT1 issue.

Romain Miginiac, head of research at Atlanticomnium and co-manager of GAM Star Credit Opportunities, noted that when UBS came to the market on 8 November with a dual tranche $AT1 deal, the first AT1 issued by UBS since the Credit Suisse AT1 write-down in March this year, “both tranches came at a 9.25% coupon or around 4.75% of spread to US treasuries”.

Romain added: “A new AT1 from a major Swiss bank – especially the largest Swiss bank UBS – was an important milestone for the market, another step towards true “business as usual” in the AT1 market. This reads very well for the market, which we see as very cheap – and adds yet another catalyst.”

He said: “Very positively, the new UBS deal ended up being one of the most successful AT1 new issues, attracting a record greater than $36bn of demand, oversubscribed by more than 10 times. Greater than $36bn of demand is equivalent to more than 15% of the total AT1 market size – reflecting very strong demand from investors.”

Looking ahead, according to Romain, record demand for UBS’ new AT1s “emphasises the strong value in the AT1 market”.

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