Before going into the technicalities of the complex nature of Additional Tier 1 or AT1 CoCo bonds, it is imperative to understand the origination of this unique bond and its place in the financial markets.
Prior to the Global Financial Crisis, there was a clear distinction between equity capital and debt. Bank debt was never designed to absorb losses without triggering a default for the issuing bank. In fact, senior debt was often considered to be “pari-passu” (on an equal footing) with bank deposits, which proved extremely problematic during the crisis.
In response to the global financial crisis in 2008, the Basel Committee on Banking Supervision (BCBS) developed the Basel III with the aim of strengthening regulation, supervision and risk management. It was introduced to improve bank’s ability to handle financial shocks and distress while strengthening their transparency and disclosure.
According to Basel III, a bank’s regulatory capital is divided into several categories or tiers of capital, which try to group constituents of capital depending on their degree of permanence and loss absorbency.
Tier 1 capital is so called because it is the best-quality capital from the regulator’s perspective. The objective of Tier 1 capital is to absorb losses and help banks to remain “going concerns” (i.e., to remain solvent, or in other words, to prevent failures). There are two layers of Tier 1 capital namely Common Equity Tier 1 capital (“CET1”) and Additional Tier 1 capital (“AT1”)
Under Basel III, banks are required to maintain a minimum amount of capital on their balance sheet and one way for banks to meet such capital requirements is through the issuance of AT1 CoCo bonds to meet the Tier 1 Capitalisation requirements. As a result, this gave rise to this special class of bonds.
Contingent Convertible Capital Instruments (CoCos) are a form of hybrid capital security with both the characteristics of fixed income and equity component that can absorb losses when the capital of the issuing bank falls below a certain level. These securities can be partially or wholly written-down or converted into equity.
Key Features of AT1 CoCo Bonds
Lowest Priority: AT1 CoCo bonds are subordinated debts and are the first line of debt to incur losses. The loss absorption nature of AT1 CoCos and high trigger levels innately results in them being having the lowest priority out of all outstanding debts for banks
Perpetuals: The equity like feature of AT1 CoCo bonds is inpart derived from its perpetual tenor and that their face values are never repaid.
Coupon Cancellation: Coupon are cancelled on non-cumulative basis at issuer’s discretion or subject to available distributable amount
Convertible Feature or Write down Feature: Upon the occurrence of a capital trigger event, either mechanical or discretionary, the bonds can either be written down or it could be converted to equity at a pre-defined conversion rate (either on market price of the stock or pre-specified price)
Treatment by Rating Agencies: All 3 rating agencies have different methodologies in issuing a rating for AT1 CoCos. However, the underlying commonality is to have AT1 CoCo bonds rated a couple of notches below the issuer’s credit rating (3-6 notches depending on the rating agency)
CoCo bonds have two key characteristics: The first is their “trigger” which then activates their “loss-absorption mechanism”.
Triggers can be either linked to mechanical rules or based upon the discretion of a supervisor:
Mechanical triggers are rules that can be divided into book-value triggers, which are typically set in terms of the book value of CET1 capital as a ratio of risk-weighted assets (RWA), or market-value triggers, which mainly aim to address the shortcomings of inconsistent accounting valuations, and so are set at a minimum ratio of the bank’s stock market capitalization to its assets.
Discretionary triggers are point of non-viability (PONV) triggers, that are activated based upon the judgment of a supervisor regarding the issuing bank’s solvency situation:
- The bank meets the conditions for resolution, but no resolution action has yet been taken;
- The bank will no longer be viable unless the relevant capital instruments are written down or converted; or
- The bank requires extraordinary public support, without which the relevant resolution authority determines that the bank would no longer be viable.
Loss-absorption mechanisms are generally structured as either Equity Conversion in which CoCo instrument is converted into common equity at a pre-defined conversion rate or Write Downs where the CoCo instrument’s principal is written down to return the CET1 ratio to the required level.
Benefits of investing in AT1 CoCo Bonds
Superior Yields and Total Returns: Due to their subordination and risk of mandatory conversion or write-off, CoCos have delivered superior yields and total returns than any other fixed-income sub-segments
Coupon reset feature reducing the duration risk: Though AT1 CoCos are perpetual, the coupons will be reset at the first call date if it is not called back, thus the duration risk is reduced significantly
Improvement in banks fundamentals and ratings: Given the banks have significantly improved its asset quality and capitalization level since great financial crisis, we see that the banks have built more capital buffer for increasing headroom for AT1 coupon payment and decreasing loss absorption risk
An increasingly mature but still attractive asset class with limited supply: The CoCo universe is expected to continue expanding but will not grow indefinitely, we see limited supply from the asset class as the most of the banks have fulfilled their need to build-up AT1 capital buffers.
In today’s yield centric environment, AT1 CoCos offer a considerable yield pickup and allows for attractive risk reward trade offs in moving down the debt structure in banks. The relatively higher volatility of these bonds also allows for investors with high risk appetite to seek opportunistic timings to enter into these instruments. As the enigmatic nature of AT1s slowly clears away, we do see great value in this asset class. Much of the risk associated with this sub-class of bonds are well managed by stronger capitalization by the banks. As banks work in greater tandem with regulatory authorities, we see their continued ability to meet the requirements set forth.