“Investors should not be complacent” to AT1 risks

Jun 29th, 2018 | By | Category: Alternatives / Multi-Asset

Investors should not be complacent to Additional Tier 1 (AT1) risks. That’s the message from Scope Ratings, a Berlin-based credit rating agency. The cautionary advice comes just weeks after the world’s first ETFs specifically linked to AT1 bonds made their debut on LSE and Xetra.

Scope Ratings warns investors not to be complacent on AT1 bank bonds

The AT1 market comprises contingent convertible (CoCo) bonds issued by financial institutions from developed European countries.

The AT1 market is largely composed of contingent convertible bonds – or “CoCos” – issued by financial institutions from developed European countries.

Previously the domain of specialist bond investors, CoCos can now be accessed cheaply and efficiently thanks to recent ETF launches from WisdomTree, who were first to market, and Invesco.

It has also been reported that Citi, Goldman Sachs and China Post Global are prepping AT1 ETFs.

The bonds are a form of hybrid debt that are intended to convert into equity or have their principal written down to absorb the issuer’s capital losses upon the occurrence of certain triggers, such as the issuer falling below a specified liquidity ratio.

Investors are attracted to the bonds due to the high levels of income they offer and their low sensitivity to changes in interest rates. They also have a low correlation with other asset classes, and thus offer the potential for portfolio managers to diversify risk and sources of return whilst enhancing yield.

Introduced in the aftermath of the 2008 financial crisis, the bonds are intended to protect bank depositors on a ‘going concern’ basis. The bonds impose losses on their holders under certain ‘stressful’ conditions, thereby reducing the risk that the bank itself will be liquidated.

The market reaches a landmark in 2018 as the earliest issues hit their first call dates. Since their introduction, the investor base has grown, and terms and structures have standardised. Scope Ratings highlights the controlled and contained reaction to last year’s write-down of Banco Popular’s AT1 securities and Bremer Landesbank’s AT1 coupon cancellation as signs that the market is maturing.

“But investors should not be complacent,” warns Pauline Lambert, executive director in the financial institutions team at Scope Ratings, pointing out that bank capital requirements have been on the rise.


WisdomTree AT1 CoCo Bond UCITS ETF
– Tracks the Markit iBoxx Contingent Convertible
Liquid Developed Europe AT1 Index
– Provides access to AT1 CoCos denominated in
– Trades on LSE in USD under ticker CCBO LN
– Total expense ratio (TER) 0.50%

Invesco AT1 Capital Bond UCITS ETF
– Tracks the Markit iBoxx USD Contingent
Convertible Liquid Developed Market AT1
(8/5% Issuer Cap) Index
– Provides exposure to USD-denominated AT1
– Trades in USD on LSE (AT1 LN) and EUR (hedged)
on Xetra (XAT1 GY)
– TER 0.39%

As well as rising capital requirements, Maximum Distributable Amounts (MDA) have also been increasing. MDA thresholds “define the levels at which banks are forced to restrict cash distributions,” said Lambert. “At the same time, the headroom to those MDA thresholds has been declining as banks balance the demands of various stakeholders.”

Scope Ratings notes that higher capital requirements are not just a function of the phasing-out of transitional arrangements; they are also due to growing supervisory expectations.

The agency points to the relevance of Pillar 2 (supplementary capital), Tier 1 and total capital requirements when determining the MDA threshold and to the latest proposals to include minimum requirements for eligible liabilities (MREL) and total loss-absorbing capacity (TLAC) requirements and a leverage ratio buffer for the largest banks.

“The bar for banks to be considered prudentially sound continues to climb. This potentially increases coupon-cancellation risks overall,” said Lambert.

Scope sums up five years of AT1 analysis in three takeaways: First, even though market participants have made headway in trying to understand the risks of AT1 securities, those risks are still relevant; second, issuer credit fundamentals remain key, given that regulatory action has led to default-like situations; third, analytical considerations need to be flexible, as the focus of European bank supervisors and regulators is constantly evolving.

From an ETF perspective, it’s clear that issuers are doing a great job opening up previously hard-to-access asset classes. And AT1 CoCos can undoubtedly add value to portfolios and are a useful addition to the toolkit. But investors should not be complacent to the risks and must, as always, perform sufficient research and due diligence, particularly when venturing into niche areas of the market.

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