AT1 bonds: what are they and what are the risks?

AT1 (which stands for Additional Tier 1) is an acronym that many people did not know until a few months ago. However, it has been in the financial news more and more lately, so Vontobel Asset Management explains what it is and the risks it entails. When Swiss banking giant Credit Suisse was on the brink of collapse and had to be rescued by UBS, AT1 bonds went into free fall. This is because the bailout of Credit Suisse wiped out the value of AT1s and those who bought them saw their entire investment go up in smoke. They were therefore treated worse than those who held shares, who still suffered losses of over 70% but did not lose all their capital.

What exactly are AT1 bonds?

Additional Tier 1 (AT1) bonds are a type of financial instrument in the category of bank capital securities known as 'contingent convertibles' or 'CoCo'. They are called 'convertible' because they can be converted from bonds into shares or, alternatively, be written off completely. Their conversion is 'contingent' because it occurs only under certain circumstances, such as when the issuing bank's regulatory capital falls below a predetermined threshold. This mechanism, known as the 'loss absorption mechanism', is the main difference between AT1 bonds and conventional bonds. It is precisely because of this feature that AT1 bonds usually offer a higher return to investors, who expect a premium for taking on the additional risks associated with such financial instruments.

Why do banks issue AT1 bonds?

Following the global financial crisis of 2008, regulators sought to strengthen capital within the banking system. AT1 bonds issued by European banks were an important part of this new system. Under the global regulatory framework known as Basel III, banks were required to have a minimum CET1 ratio (which includes common equity and retained earnings divided by risk-weighted assets) of 4.5% and regulatory capital of at least 8%. However, national supervisors often had higher minimum requirements for large banks. To meet regulatory capital requirements, banks could use AT1 and Tier 2 capital, which amounted to about 1.5% and 2% of their risk-weighted assets, respectively. While US authorities allowed banks to use preferred shares in the consolidated market to meet AT1 capital requirements, European authorities created AT1 bonds in 2013 as part of their banking crisis management regime.

The 3 key features

1) Loss absorption mechanism: This mechanism kicks in when the issuing bank's Tier 1 capital (CET1) falls below a predetermined threshold, usually around 5.125% or 7% of CET1, depending on national regulations. In this case, the bond is automatically converted into equity or fully written off, depending on the specific terms of the bond document.

2) Lack of a fixed maturity date: AT1 bonds do not have a fixed maturity date, but can be called subject to regulatory approval. There is usually a non-call period of 5 to 10 years, after which investors can expect the bond to be redeemed and replaced by a new issue. If the bond is not called, the coupon may be recalculated based on reference rates such as those of the underlying swaps or government bonds.

3) Non-cumulative and discretionary coupons: AT1 bonds have coupon payments that do not accumulate if they are not paid. These missed payments do not become a liability for the bank and do not constitute a default or credit event.

Assessing the risks

The most obvious risk of these bonds is the possibility that the bank's financial position deteriorates to the point where the CET1 ratio falls below the trigger level. In this case, investors holding AT1s could lose all their invested capital or receive shares in a bank with a low level of capital. However, it is important to note that large European banks, which are also the largest issuers of AT1s, tend to have strong capital positions. In the first quarter of 2022, the average CET1 ratio for the European banking sector was 14.9%, meaning that these banks tend to have reserves well above the trigger levels for their AT1 securities. Therefore, the risk of extremely large losses is generally limited. However, given the complexity of this asset class, the use of professional asset management is essential.

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