Diligence Due in AT1 as Spreads Tighten

Since the start of the year credit markets have been very well supported, reversing much of the sharp period of spread widening we experienced in the final quarter of 2018.
This backdrop of supportive central banks and economic fundamentals has created an environment where speculative and higher-beta borrowers can tap the market, enticing investors with relatively attractive yields. This is a phenomenon that typically occurs during periods of credit spread tightening and, in particular, late in the cycle.

Which brings me to the Additional Tier 1 (Coco) sector, one of our favoured topics and an area where considerable relative value can often be found, though always with the caveat that investors need to be extra diligent and highly selective in these securities. Now that credit markets have tightened back in again and yields are comfortably affordable for most issuers, we have seen a steady flow of smaller and non-frequent borrowers come to the market, which naturally require an even higher level of scrutiny.

All banks theoretically should look to maximise their AT1 issuance, since it is an efficient way of issuing core capital, so we welcome looking at new names as they enter this sector. One of the risks, though, in our opinion, is that not all banks are suitable for issuing this deeply subordinated type of bail-in debt and investors need to be extra diligent and not just be tempted by an attractive coupon.

In the past week or two we have turned down a number of transactions where the credit metrics of the borrowing bank did not pass our initial scrutiny, even though the yield would have made a welcome addition to a portfolio. No matter how high the coupon on an AT1, in our view it can never offset the risks presented by a high level of non-performing assets or a low buffer to the minimum capital requirements of the borrower, even when the backdrop for banking remains as positive as it is currently.