Why inflation risks are still tilted to the upside
The ECB's most recent review into safeguarding the financial system covered an array of topics, from countercyclical buffers to crypto. However, the review's discussion on potential changes to the AT1 instrument pricked our ears. We are long-term advocates of AT1s and believe they offer investors attractive relative returns in a banking sector that has dramatically strengthened since the global financial crisis. The latest report is not the first time that there has been debate about the flaws of the asset class. However, in practice, we think any significant changes are unlikely.
One characteristic of AT1 bonds that garners the most attention is the trigger, whereby the instrument is written down or converted into equity. We have long argued that the trigger feature is irrelevant because, with a CET1 ratio of 5.125%, it is so far below the point of non-viability of a bank (the point at which a regulator would intervene). The review describes the trigger as 'obsolete'; however, if the regulator raised the trigger any higher, the sector would require a very punitive coupon for banks or become uninvestable. These unintended consequences mean we see any change in the trigger level as unlikely and would support getting rid of it in its entirety. It is also worth noting that any change in the trigger level would be bullish for outstanding AT1s (a market now over $250bn) because it would likely lead to grandfathering and AT1s trading as quasi-bullets to their next call date.
The review also covered AT1 coupon payments and whether only profitable banks should be able to pay them. First, we must examine whether this would have a material effect on safeguarding banks in volatile times. Cancelling AT1 coupons in 2020 would have, on average, increased CET1 ratios by around 15bp. This relatively low increase compares with CET1 ratio rises of over 100bp following the imposition of dividend bans in the same year. Moreover, whereas banks can compensate for skipped dividends with 'super dividends', AT1 coupons must already be non-cumulative, effectively subordinating AT1s below bank equity. As a result, investors and issuers would likely institute a pushback. We do not see any change to blanket AT1 coupon bans in the future for these reasons. However, we could see more proactivity surrounding special scenario banks, a reminder that investors must be highly selective when investing in subordinated debt.
Finally, the review underlined the need for AT1 calls to be economical for issuers, whereby an existing AT1 must be refinanced by another with a similar or cheaper spread. This situation is already in operation, with issuers balancing the economics of refinancing against the need to keep investors onside (as fully understood by the regulators). In reality, our conversations with issuers and market participants indicate some flexibility exists for issuing banks. Moreover, we believe this flexibility will continue, with banks wishing to maintain the market's perception that they remain friendly to bondholders and preserve the levels at which any outstanding debt trades. Meanwhile, the above serves as a timely reminder that investors must carefully select the specific AT1 bonds, as reset spreads of AT1s differ between bonds from the same issuer.
Despite the ECB's recent review bringing some previously debated points surrounding AT1s to the forefront, we believe any changes would create undesired, real-world consequences if implemented. Therefore, any significant changes are unlikely. Subsequently, with robust bank capital buffers and profit generation improving in a rising rate environment, we believe that while still being selective, investors can take advantage of some compelling returns offered by AT1s.