Not All AT1 Extensions Are Bad
There has been a lot written recently about indiscriminate forced selling that has resulted in some unprecedented spread levels in the credit markets. Some of the most extreme examples we have seen have been bank capital bonds trading significantly below par, despite having their call option exercised and being set to redeem at par (as close to ‘free money’ an investor can find). We have also seen a number of bank capital bonds that are within months of their call dates trading significantly below par.
Of course the current situation has created a backdrop where refinancing options are restricted, and it may be more economically viable for these bank borrowers to extend. We have seen and heard many comments that automatically associate a potential non-call as being a sign of bank weakness. We disagree, and would argue that in some cases this may be a short-term technical decision and a sign of prudent management; it can also be an opportunity for investors.
This brings me to the announcement this morning that Aareal Bank, the specialist German lender in the property sector, is going to extend its AT1 bond beyond the April call date. Aareal is a bank we have followed with interest and we have been discussing on the desk for some time whether or not this bond will be extended for another year. Aareal has a prudent and experienced management team which exhibits strong transparency and governance, and the institution is strongly capitalised with a CET1 ratio of 17.1% (Sep 30, 2019) and a total capital ratio of 26.7%; the bank could technically call its expensive AT1 without re-financing. That said, small inconsistencies at the regulatory level led us over the past month or so to question whether it would be to the benefit of Aareal (and its investors) to delay the call. Having an annual call option, rather than every five years, offers Aareal the flexibility to re-address the issue once there is greater clarity.
This uncertainty that has created this complication for smaller banking borrowers is a little reported technical relating to the Internal Capital Adequacy and Assessment Process (ICAAP). ICAAP relates to the internal models that banks need to operate in order to assess the economic risks they face. Recent volatility has increased the emphasis on this requirement. Now, previously banks have been able to use their outstanding AT1 debt to meet their ICAAP requirement, but new interpretation by the European Central Bank appears to outlaw this. There has been no definitive rule from the ECB to clarify this point, and banks are unclear whether the grandfathering of the old AT1 (that did count for ICAAP purposes) will still be allowed. However, it is fair to assume that a degree of common sense and flexibility will be given, at least until the uncertainty stemming from COVID-19 has passed. For this reason it may be prudent for smaller banks to maintain any existing AT1 to cover their ICAAP requirements until market volatility subsides and the ECB finally clarifies its position.
We have no doubt that if a bank does extend an AT1 beyond its call, then current market sentiment will err on the side of caution and the subsequent market price will immediately weaken (assuming a price to perpetuity). But maybe investors should consider each case independently and consider the rationale and the potential opportunity. In the case of Aareal Bank the management decision is understandable in our view; should the market panic and begin to offer extended AT1 bonds at a heavy discount, then investors could see this as a real opportunity over the medium term.