Do you know Luminor Bank or Landsbankinn? Probably not. Yet, the issuance of their first AT1 bonds in February gathered a lot of interest from investors, highlighting a key trend: the entrance in the last couple of years of smaller names into the AT1 market. We see several reasons why investors should take notice.
Created by Basel III in the aftermath of the global financial crisis in 2008, bank contingent capital bonds – known as Additional Tier 1 bonds, or AT1s – have become mainstream. In Europe, with a size of EUR 210 billion, the AT1 market is unsurprisingly dominated by the largest and national champion banks. They account for more than 90% of the market and typically issue AT1s with a benchmark-size between 0.5 billion and 1.5 billion.
The rest of the market, although a tiny 8%, is far more interesting in our view. It’s made up of a cohort of smaller and less known banks, which have belatedly decided to issue regulatory capital under the AT1 format as the asset class gained growing acceptance among investors.
What kind of names are we speaking about? Just to name a few across countries: Arion, Oldenburgische Landesbank, Grenke, Aareal, CCF Holding, Quintet, NIBC, Van Lanschot, and BFF, among others. So, very different business and credit profiles, which may enhance portfolio diversification for benchmark-agnostic investors. But, more importantly, a few common features that make them worth a look:
With a bond size typically below 300 million (mostly in euros and US dollars), these AT1s are arguably less liquid, and may not be suitable for investors needing flexibility. But in compensation, they tend to offer an illiquidity premium in the 50-100bps range – a valuable extra carry for yield-orientated long-term investors.
These AT1s are less prone to market volatility thanks to a local, specialised and stickier investor base. Non-dedicated AT1 investors tend to own big names: traditional fixed-income funds based in Europe buy Santander or Credit Agricole AT1s to boost returns, not Marex. Asian private clients buy HSBC or UBS AT1s, not Kommunalkredit Austria. On top, these “tourist” investors are not buy-and-hold and rather trim risk in weak markets. This means that in episodes of weak markets, big AT1s tend to sell-off more than small AT1s
Most of these names are unlisted. This implies no equity and no credit default swap either. The impossibility to short the stock or the credit can shield these names from the vicious circle created by the toxic mix of derivatives trading and leverage, which often exacerbates price actions on big banks.
Several of these names are potential acquisition targets by larger banks – usually a welcome price upside for AT1 owners
Smaller doesn’t mean riskier. Although a careful credit analysis and name selection remain crucial, we would note that many (not all) of these smaller banks have strong capital ratios, stable business models, consistent earnings, and patient private owners, among others
However, AT1s remain a highly complex instrument, classified as “risky products” that are limited to qualified and institutional investors. Risks to be aware of include their potential conversion at times of market instability, which could potentially impact their value, as well as their subordinated structure in the repayment order behind other creditors.
Another distinguishing aspect is their perpetuity. Since they do not have a fixed maturity date, the issuer may decide to redeem the bond at its convenience.
For investors willing to accept the risks, building some exposure to this subset of the AT1 market while keeping portfolio liquidity risk at acceptable levels makes sense. Compared to large banks, it offers higher yield, lower volatility and higher average Common Equity Tier 1 (CET1) ratio. Enough said.
By Benoît Robaux, Portfolio Manager at J.Safra Sarasin
