Anatomy of the European Banks Rout – AT1 bonds

European bank stocks have collapsed so far this year whilst their credit default swaps (CDS) have risen rapidly. Surely the credit and equity markets are telling us something? – Europe’s nascent economic recovery is over? Negative rates are killing net interest margins? They don’t have enough capital?…the list goes on. Whilst all the above cannot be ignored and investors need to select bank stocks carefully, we think the wholesale selling pressure of bank stocks may have an altogether different origin – AT1 bonds.

AT1 (Additional Tier One) bonds were borne out of the financial crisis. They form part of a bank’s total capital ratio, but can contribute no more than 1.5% towards the total capital ratio [1]. The first true AT1 was issued by BBVA in 2013. Their defining characteristics are flexibility, with the ability to suspend coupons and convert into equity should a bank’s capital position deteriorate sharply. Due to these features they were issued with attractive coupons (high single digits), which in an overall low rate environment drew fixed income investors like a moth to a flame. Although they are perpetual bonds, the issuer has the right to call them, generally after five years. The first call dates are in 2018. It is fair to say that most investors expect to be called and thus price(d) these instruments on a “yield to call” basis.

Then, in mid-December last year, there was a shift in regulatory guidance (in the form of a letter from the EBA and later endorsed by the ECB) which theoretically increased the risk of AT1 coupon deferrals. Essentially the regulators guided that Pillar 2 capital requirements be positioned below the CBR (Combined Buffer Requirement), increasing the minimum capital a bank needed before it could distribute earnings (e.g.: AT1 coupon payments and dividends) i.e.: banks’ CET1 capital now needed to cover Pillar 1, Pillar 2 and CBR requirements. If a bank cannot meet these levels, then it would be subject to an MDA (Maximum Distributable Amount) calculation which would limit distributions. Additionally, banks’ total capital ratios are required to have certain minimum levels of AT1 and Tier 2 capital. Levels below this contribute to reducing the so called buffer, below which the MDA would be activated. The new guidelines have had the effect of reducing the median buffer for European banks by 2.5% -where previously a coupon deferral was unthinkable, it now had to be considered [2].

Added to the risk of coupon deferral, falling AT1 prices themselves have meant that the prospect of these instruments being called at their first call date is also reduced, as calling them at low prices (and thus high yields), means refinancing costs increase rather than decrease for banks. Investors have thus also had to shift valuation from a “yield to call” basis, to a “yield to perpetuity” basis - implying any further price falls accentuate the probability of extension, thus knocking valuations further.

Understandably holders of AT1’s have looked to reduce their positions or exit entirely. However, the problem has been liquidity in the secondary market. With an absence of buyers and an unwillingness/inability of investment banks to be the providers of liquidity by stepping in and taking on the inventory (due to balance sheet constraints post the financial crisis), prices have fallen sharply. Additionally, fund flows in the high yield market (of which AT1 is a part) have turned deeply negative since December, compounding the selling pressure. With no alternative, the owners of AT1’s have looked to hedge their exposure, initially by buying CDS and then by shorting the underlying bank equity.

The equity market participants, seeing the spike in bank CDS in the credit markets have taken fright, perhaps believing that the credit market was seeing something in the fundamental outlook that they hadn’t – a natural vicious circle has ensued. All the while, there remains no buyer of last resort to step in and provide a floor for the AT1 selling – begetting more selling.

Whilst further clarity regarding Pillar 2 repositioning and its time horizon would be helpful, it doesn’t solve the need for a “buyer of last resort” to clear the market and instil confidence. It would be difficult for the ECB to fulfil this role owing to moral hazard, as officials have consistently said that they believe bond holders should be bailed-in as part of a bank’s rescue. This leaves the ECB in a dilemma as other policy tools such as lowering the deposit rate further would incrementally hurt bank earnings. Without a short term fix, confidence in the AT1 market will likely only return as issuers pay their coupons.

The technicalities in the AT1 market and the resulting hedging strategies to us are a compelling narrative in rationalising the indiscriminate selling we have seen thus far this year in European banks stocks. Whilst there is always uncertainty in the outlook, the underlying European macro conditions remain robust and hence the markets willingness to price in a European recession for the sector, to us, seems a bit of a stretch.