Are BBBs still the place to be?
One of the risks the AT1 investor faces is extension risk. Issuers have the option to call these bonds at their discretion and there are no step-ups in the coupon if the bonds are not called. While banks typically take a number of factors into account when thinking about calling and refinancing versus not calling and extending, the simple economic impact is of course among the most important.
It seems to us that some investors look at the COCO index, see that the average cash price of bonds in the index is in the mid-80s, and quickly conclude that the average AT1 bond might not be called. In addition, they hear central banks almost on a daily basis underlining that higher rates for longer is the new norm. How can it be economical for a bank to call a 5% coupon AT1, and issue a more expensive replacement, if the Fed Funds rate is likely to peak in the mid-4% area and stay high for a relatively long period of time? Some investors seem to conclude a significant portion of the AT1 market will just never be called.
However, there is one important factor missing in this analysis: banks do not carry AT1s on their balance sheets at the fixed coupon that investors periodically receive. There are some accounting considerations with this subject but conceptually one can think of it in the following way. When a bank issues an AT1 with a first call in five years’ time, it concurrently enters into a five-year swap transaction whereby it receives fixed and pays floating rates. For example, if a bank issued a dollar AT1 at a spread of 400bp a year ago, when the five-year swap rate was close to 1%, then the coupon would have been fixed at 5% per year until the first call. At the time of issuance the bank would have traded a five-year swap as described above; the bank carries the AT1 as an instrument that pays out the floating rate in dollars plus 400bp.
Today, this hypothetical bond would very likely be trading at a cash price in the low 80s, given five-year dollar rates have moved up by 300bp and spreads have widened significantly. Let’s assume that eventually in the next four years spreads normalise but rates remain relatively high as central banks have to keep some pressure on due to inflation. Come the first call, let’s say this bank can refinance its AT1 by issuing a new five-year AT1 at a spread of 375bp. Let’s assume though that rates have only moved down marginally. If the five-year swap only declined from the current 4% to 3.5% by then, this bank would be refinancing a 5% AT1 with one issued at 3.5% + 375bp = 7.25%. This seemingly uneconomical refinancing is in fact economical. The bank was carrying the old AT1 at floating rates +400bp. Given that AT1s have no step-ups, if the bonds are not called the coupon would reset at five-year swaps on the day of the non-call +400bp (the spread at issuance). The new 7.25% five-year issue would also be swapped to floating, and would therefore be carried at floating rates +375bp.
The floating nature of the AT1 once swapped from fixed to floating means that as the floating rate goes up, so does the interest cost for the bank. This is offset from a margins point of view by the fact that when rates go up, banks charge higher rates for lending money to companies and customers. In fact, as we are witnessing at the moment, banks’ margins tend to increase when underlying rates increase.
In conclusion, the economics of calling is driven by spreads. While we do think there are certain AT1 bonds that will likely not be called at their first call dates over the next few quarters, it’s important to keep in mind that it might be completely economical for banks to call a 5% bond and issue a new 7.25% one in its place. This analysis highlights that call dynamics are very different for banks than they are for corporates (which are usually not interested in swapping their liabilities from fixed to floating).
Importantly, conclusions cannot be drawn simply by looking at bond prices or at the relatively low coupons of outstanding AT1s. Indeed, assuming a given AT1 bond will never be called is similar to assuming that spreads will never revert to normalised levels. History shows this is extremely unlikely.