Has the UK risk premium gone too far?
On Friday Spain’s Banco Sabadell announced it would not be calling its 6.125% Additional Tier 1 (AT1) bonds due to “current market conditions.” This is the first AT1 to not have been called on its first call date in 2022, however it is understandable considering the violent move upwards we have seen in both rates and credit spreads in recent months. Subsequently, the market expected this decision and it was fully priced in.
What is the impact of the non-call? Looking at this particular AT1, it has a reset of five-year euro swaps +605bp, meaning that following the non-call the new coupon will be around 9.125%, roughly 300bp higher than the original. The next feature is that the AT1 is now callable on a quarterly basis, a structure that for some time we have argued is extremely important; it gives issuers more flexibility on the timing of an AT1 call and associated refinancing, while for investors it tends to reduce the pain of a fall in price well below par as a potential call is always on the horizon. Indeed, this Sabadell bond with a new coupon of around 9.125% and a current price of around 90 is now showing a yield of 15.39% in euros (17.36% in sterling or 18.21% in dollars) if we assume a call in two years’ time. Obviously this yield is higher if the bank calls sooner and lower if it calls later.
It is worth noting that Sabadell has said it sees this as an individual bond-specific case, and does not reflect any change their broader approach towards bondholders. In addition, Sabadell’s latest results saw capital increase and non-performing loans (NPLs) decrease, and the bank (like the vast majority of European banks) should see a real pick-up in net interest margin in Q4 2022 and going into next year due to the beginning of the ECB hiking cycle. Consequently, the bank looks in robust financial health to refinance its AT1s when market conditions are more friendly. We believe this is a good example of why concerns over extension risk in AT1s are overdone, and the yields on offer in the sector look attractive on both an income and potential capital gain basis. Indeed, Sabadell’s non-call decision hasn’t produced a reaction in AT1s more broadly, which perhaps shows the market has matured from the episodes of quick contagion we saw six or seven years ago.
Elsewhere in AT1 land last week we saw the UK’s Shawbrook Bank announce a contingent call/exchange on its outstanding 7.875% AT1 notes. This gave investors the option to rotate into a new AT1 with a spread 100bp higher than the existing issue, resulting in a coupon of around 12.125%. Had the bonds not been offered for exchange the new coupon on the old issue would have been reset to approximately 11.125%, so this approach effectively offered bondholders five points of upside on the existing issue and was a way of keeping investors on the journey with Shawbrook. The new AT1 also has a six-monthly call feature after its five-year fixed rate rather than a five-year rolling call; similar to Sabadell’s quarterly call structure, this gives the issuer more flexibility in the future as well as likely giving investors more price stability.
Two completely separate outcomes, but two examples of how the structure of each AT1 bond is important, and also of how banks continue to manage their relationship with bondholders. Banks do have options and the potential downside for bondholders is often mitigated by these actions.