Steve: Since the Global Financial Crisis (GFC) banks have been forced by strict regulation to significantly build the quality and quantity of their equity capital bases, as well as cleaning up asset quality and improving the liquidity of their balance sheets (see display below). These improvements in credit fundamentals are the key reason supporting our positive view on subordinated bonds issued by financials. In essence, large equity capital bases provide a sizeable buffer between bondholders and potential loss absorption.
However, investing in banks’ debt is not an easy task given the complexity of the capital structure, particularly in the most subordinated debt known as Additional Tier 1 (AT1), or in the jargon, “CoCos”. We believe that this part of the capital structure is a particularly attractive opportunity, and it currently provides an average yield of around 5.5%*. But it needs to be considered carefully – it is important to review each issue’s terms and conditions, as these can vary and are a key driver of how these bonds trade. This complexity provides an attractive opportunity to add value by specialist research and skilled security selection.
We have invested in Legacy Tier 1 (the fore-runner of the new AT1s) since 2000 and in AT1s since 2013 – the latter market has grown globally to over US$400bln in outstanding (see display below). In the current lowrate environment, there are very few relatively large and liquid markets that can provide comparable levels of income. In time, as the AT1 market matures, new issuance will reduce, repeat issuance will be commonplace, and these bonds will become more familiar to a wider investor base.
Jørgen: We consider a global opportunity set across all financials and across each issuer’s capital structure, but our strategy is largely to stick to the higher quality issuers, where we can apply both in-depth fundamental and quantitative (quant) research—an approach we call ‘dual advocacy’. We then apportion relatively higher weightings to what we consider the best structure and currency bond for each of these issuers.
We use a team approach in managing the Portfolio. Including a security in the portfolio is the result of extensive daily discussion between me and the broader PM team, Steve (and his global team of fundamental analysts) and Sahil, with input from our dedicated financial traders globally. Consistent with the AB investment approach, we combine fundamental and quant analysis. Given the complexity of AT1s, we have developed a dedicated quant AT1 model which allows us to determine relative value across and within AT1 issuers, and this gives us valuable insights into the overall tone of the AT1 market.
Sahil: AT1s are complex securities with credit, equity and volatility features that mean they can behave in very different ways depending on market conditions. It is therefore vital to understand how to appropriately price the different features and determine a fair value for these instruments and attribute what is driving their performance.
Our AT1 model went live in 2016 and predicted a steep fall in AT1 prices which had never occurred in this market before (display, below). We were able to identify the drivers of the sell-off, and so have an informed debate on which securities to select on any market rebound. We have continued to increase model coverage and look at innovative ways to leverage it further including better risk management.
Most risk models are not designed to tackle AT1s and do not correctly identify the risks inherent in these instruments. Our model allows us to create surfaces that price these instruments across moves in spreads, equity and volatility and therefore far better identify how the various types of negative convexity affect these assets.
But even the best quant model has limitations. Each issuing bank is different, and each AT1 issue may have very specific features that can make a difference to its fair value. That’s why we need our fundamental analysts to research the small print in the terms of each bond, and to understand the nuances of accounting and regulation across different countries. The dual advocacy approach is key to our fixed income process generally and is especially important in the financials’ sector.
SahilJørgen: AT1s are complex securities with credit, equity and volatility We believe the Portfolio provides a compelling risk-return opportunity when viewed against both bank equities and corporate high-yield. We think AT1 securities have the return-generating properties of equity, but with a more stable return pattern. Within the financial sector, they can be a good diversifier from existing holdings in banks’ stocks and a means of de-risking equity exposure. The benefits include lower volatility (6-8% versus 25% for AT1s and banks’ stocks respectively), shallower drawdowns, steady cashflow and potentially higher returns. In fact, since the launch of the AT1 market, those securities have outperformed bank equity on a cumulative basis by almost 50%2—a startling difference—and have outperformed global high yield by almost 13% (Display, below ).
We expect this trend to persist, as European banks continue to struggle to improve profitability given the low rates, flat yield curve and low growth environment in Europe. This is the main reason for the underperformance of banks’ equity over the last few years. On the other hand, bank bonds, including AT1s, have performed well due to stronger and more liquid balance sheets with higher capital and better asset quality. AT1s also represent an alternative to high-yield corporates, without sacrificing yields. In fact, our portfolio is mainly split between BBB investment-grade and BB high-yield issues, but with yields that are more akin to lowerquality single-B and CCC type high-yield corporate issuers.
1 AT1 securities are designed to provide an additional capital buffer to improve banks’ solvency. These bonds are a category of Contingent Convertibles (CoCos)—a more complex type of bond which converts to equity or is written down should a pre-specified trigger event occur. The risk of investing in these types of instruments is that the holders of CoCos will suffer losses ahead of other equity investors and may not receive the return of their investment. The generic term ‘AT1s’ is generally used to refer to CoCos that are classified as Additional Tier 1 capital under the Basel III rules.
2 Cumulative returns since the launch of Bloomberg Barclays European Banks AT1 Index through 30 April 2019