Yield-hungry investors are quickly regaining their taste for deeply subordinated bank bonds. Some of these securities offer appetizing yields, but it’s important not to overindulge.
Deeply subordinated bonds issued by Europe’s banks to satisfy tougher regulatory requirements are one of the region’s trendier investment opportunities. The regulatory framework that emerged after the global financial crisis forces banks to hold a minimum level of common equity capital. On top, banks must hold various tranches, or tiers, of debt capital with different layers of subordination that are intended to soak up losses if banks run into trouble.
These include some plain-vanilla senior unsecured, Tier 2 and Additional Tier 1 (ATI) securities—also known as contingent convertible (CoCo) bonds. Each tier has different loss-absorption characteristics. AT1s lie at the bottom of the debt capital stack, and can have their coupons suspended, be converted into shares or even get written off entirely.
These deeply subordinated bonds can offer attractive risk-adjusted yields at a time when yield-friendly opportunities have dwindled. This is driving a surge in demand for these securities, particularly AT1s, whose yields offer the strongest pickup over debt higher up the credit hierarchy,
APPETITE HASN'T ALWAYS BEEN GREAT
Investors haven’t always been eager to snap up AT1s. Around this time last year, these bonds sold off when investors worried that some banks might stop paying coupons on their AT1 bonds.
What sparked these concerns? It became clear that Deutsche Bank’s weak capital position and sluggish earnings power left it nearing triggers for AT1 coupon suspension: its common equity capital buffers looked meager, as did special reserves needed to pay coupons, known as “available distributable items” (ADIs). Deutsche Bank took great pains to quash the anxiety, stressing its commitment to building up its common equity and ADIs, as well as reducing risk in its balance sheet.
The episode revealed the complexity of AT1 bonds. Investors began to hone in on the size of banks’ common equity capital buffers and ADIs. These looked skimpy at several European banks this time last year.
MUCH HAS MOVED ON
A lot has changed since then. First, regulators have significantly cut back their requirements on buffer size. Second, banks have steadily been building up their buffers and ADIs and derisking their balance sheets. As a result, many have comfortably distanced themselves from coupon suspension triggers.
Supply and demand dynamics have also been supportive. New AT1 issuance has generally underwhelmed expectations over the last year or so—and looks set to stay relatively muted despite the recent revival in investors’ appetite. This could underpin further tightening of AT1 yield spreads.