European Bank Bonds: From Uninvestable to Irresistible?
March 15, 2017
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
Greater Risks for Greater Return Potential?
We think select AT1 and Tier 2 bank bonds can offer compelling return potential. But big differences between individual banks’ bonds mean they need to be analyzed name by name. Individual bond indentures need to be scrutinized carefully, as do issuing banks’ underlying fundamentals: are banks generating enough cash to keep buffers comfortable and to build up ADIs to pay coupons? Technical indicators that trace market trading patterns are important. There are many more ready buyers of these bonds than last year—indeed, AT1s have become a largely consensus trade among big bond investors. But it’s risky to overpay for bonds that could be tricky to sell at the right price.
Regulatory changes are a further challenge. The current Basel 3 framework is being finalized and could see banks’ common equity capital buffers being revalued lower. Could this push banks closer to coupon suspension triggers, reigniting the concerns that plagued AT1s last year?
In addition, this type of debt is more highly correlated with equity markets than some other fixed income securities, so it could prove particularly vulnerable if equity markets sell off. And because it’s more sensitive to financial-market moves, it could be at the sharp end of volatility triggered by this year’s busy political calendar in Europe or by concerns about potential shifts in central bank policy (like higher interest rates or any tapering of the European Central Bank’s bond-buying program).
Perhaps a more likely check on the current exuberance for AT1s could be a weaker bank nearing triggers for coupon suspension. Spain’s Banco Popular is one potential candidate.
Be Selective with European Bank Bonds
We’re most comfortable with bonds issued by Europe’s stronger, national champion banks. These benefit from sizeable equity cushions, limited exposure to riskier lines of business and relatively healthy earnings prospects.
We’re finding that strong investor demand for new AT1 and T2 issuance is squeezing some of these bonds’ yields down to levels that don’t seem adequately to compensate investors for the additional risks they’re taking. As a result, we think it’s particularly important to stay disciplined in the primary market and not to chase after bonds whose yields look overly tight.
Deeply subordinated bank bonds represent a complex—and potentially volatile—opportunity set, But, in our view, select AT1s and T2s have the potential to satisfy even the most exacting appetites.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.