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AT1 calls in 2018

29 November 2017 by Felipe Villarroel

Next year will be an interesting one for AT1 investors. The first batch of European AT1 bonds were issued back in 2013 and their first call dates become due in 2018. As we have commented in the past, extension-risk beyond the call date is one of the key risks that AT1 investors face and therefore needs to be carefully assessed, particularly as there are no step-up incentives in these structures. As such, the so-called reversionary rate of each bond needs to be considered as to the likelihood of the call being permitted by the regulator. Back in 2013, inaugural AT1 bonds were issued with high coupons compared to the levels currently being printed, which effectively means that their reversionary rates are relatively high, thereby increasing the likelihood of them being called (as they can re-finance at more attractive levels). We therefore expect few surprises as to the callability of these early deals in 2018.

The first AT1 to reach its first call-date next year is an old favourite: BBVA 9% Perp callable in May 2018, which has a reversionary rate of 826.2 bps over the prevailing 5yr US$ swap rate. With such a high reversionary rate, we anticipate that this bond will get called in May, but our confidence around this event is increased by the underlying capital make-up of the institution. By this, we mean how much AT1 capital the issuer is carrying into the specific call-date. As a reminder, banks are allowed to cover 1.5% of their RWA (risk weighted assets) with AT1 bonds as part of their total capital ratio. They can issue more than 1.5% but the regulator will not consider anything above this number as capital, and hence any excess is punitively expensive for the borrower. BBVA reported Q3 numbers a few weeks ago; revealing their AT1 bucket was circa 1.7% of RWA. In addition, more recently they  issued another $1 billion of new AT1s in mid-November, taking their AT1 total considerably above the 1.5% threshold. So when BBVA approaches the regulator closer to the call date next year to ask permission to call the 9% perps, they will no doubt highlight that their AT1 capital is already in excess of the 1.5% of RWA and that calling the old bonds is therefore both viable and efficient.

This assessment of the capital stack is an important part of the analysis when considering the extension risk as the first call dates approach for AT1s, particularly for those with low reversionary rates. If the issuer is carrying AT1 capital that is significantly higher than 1.5% then it will be more likely they call an AT1 bond, even if reversionary rates are relatively low. Conversely, if the first call date of an AT1 with a low reversionary rate is looming and the issuer has a low amount of AT1 capital outstanding, then those bonds should be expected to extend.

With many call dates becoming likely maturity dates now for these bonds we have seen the formation of credit yield curves, as opposed to quite flat curves while maturity was uncertain. For securities with wide spreads the credit curves can be quite steep, and this gives investors the chance to invest optimally along the yield curve to enjoy roll down gains. These roll down gains will be a material part of returns in an environment when risk free yield curves start making their move upwards.

Remember the curve is usually your friend, in a period where you may not have as many as you thought!

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