2014 Review – 2015 Outlook

After a year of two halves, Bank+Insurance Hybrid Capital surveyed leading players in the hybrid market, primarily on the buy-side, to find out what lessons can be learned from the highs and lows of 2014, and what they expect in 2015. While there are reasons for optimism, the participants suggest that the market’s limits have become clear.

 

Michel Baud, portfolio manager, BNP Paribas AM

Dierk Brandenburg, senior credit analyst, Fidelity

Francesco Castelli, head of investments, Method Investments & Advisory

Ghislain Cortina, portfolio manager, credit strategies, Boussard & Gavaudan

François Gignoux, portfolio manager and vice president, and Dan Karsenty, portfolio manager and vice president, Eiffel Investment Group

Lloyd Harris, senior financials credit analyst, Old Mutual Global Investors

Vincent Hoarau, head of FIG syndicate, Crédit Agricole CIB

Robert Montague, senior financials analyst, ECM

Örjan Pettersson, portfolio manager, credit markets, SEB Investment Management

Participants responded in late October and November

The mood in the AT1 market lately is in stark contrast to the frenzy of January. What were the main triggers for the turnaround in sentiment mid-year?

Vincent Hoarau, CA-CIB: Primary market supply in AT1 format was high during the first half of 2014, reaching Eu32.5bn equivalent. The market was one way, and it was just too fast and too furious for the nascent asset class. We approached the 5% headline coupon in euro PerpNC5 format in primary, where more and more issuers printed the biggest possible size at the tightest possible spread. In the secondary market bonds stopped performing. At the beginning of the summer the correction was overdue.

The geopolitical situation in the Ukraine, the Banco Espírito Santo misfortune, the recurrence of some negative macroeconomic headlines, and of course Bank of America Merrill Lynch’s decision to pull AT1 securities from the global high yield index offered an explosive cocktail. The purge kicked off with requests for bids by forced sellers and this spread with opportunistic bondholders urged to take profits. On average, we are still trading 75bp-100bp off the pre-summer lows.

You only have to look at the decrease in oversubscription levels in primary to gauge the overall damage and the drop in demand. Take the recent Deutsche Bank, for example: it pushed the size of its PerpNC10 AT1 to its upper limit of $1.5bn in early November and the bonds have traded down since. The total books closed at $3.6bn, compared with a total deal size of Eu3.5bn equivalent for their inaugural, multi-currency AT1 in May.

Örjan Pettersson, SEB (pictured below): There is still a limited amount of natural buyers of AT1. We believe this, in combination with heavy supply, explains the sell-off. Contagion effects from the weak high yield market might also have played a part.

Michel Baud, BNP Paribas AM: Firstly, valuations were too tight: at an average yield of 5.2% for the Barclays Contingent Capital index at the beginning of June, investors did not feel sufficiently compensated for the risk.

Secondly, Banco Espírito Santo this summer served as a reminder to investors of the risks of loss absorption.

Lloyd Harris, Old Mutual: Geopolitical fears probably had something to do with it, but ultimately the initial turnaround was everything to do with high yield outflows and positioning. Everyone was fairly long high yield and AT1, but because AT1 issuances are large, they tend to be the most liquid, so in the event of high yield outflows they are the first to go because they are basically easier to sell than your typical illiquid high yield bond. So I am pretty sure that when we saw the high yield outflows in the middle of the summer, that was the reason AT1 got hammered.

I don’t really believe it had anything really to do with the fundamentals of the issuers. You’ve only got to look at the difference between the performance of the AT1 market at the time and at the other parts of the bank capital structure: if you look at Lower Tier 2, it didn’t move a great deal; it was confined to AT1. And that tells me it hasn’t got a great deal to do with bank fundamentals, frankly.

Francesco Castelli, Method: From a quantitative perspective, AT1 market performance looks very much like a slightly higher beta version of the High Yield market: most of the BAML Contingent Capital Index returns can be explained by the US High Yield Index behaviour. Digging a little deeper into the statistical evidence, we find that the causality link runs from HY to CoCos and not vice versa. This confirms the widespread feeling that high yield funds have recycled heavy inflows into the AT1 market at the beginning of the year. With the sharp reversal of fortune in the last few months, outflows were met by limited market-making commitment from the dealer community, resulting in a painful underperformance of the bank capital sector.

Dan Karsenty, Eiffel: It is worth noting that the AT1 asset class benefited from an overall benign market in the first half of 2014. At that point, we saw what seemed like a growing investor base and a buoyant asset class. Back in June, it felt like every single investor was looking to invest in AT1. Then nervousness and weakness emerged in July and several events reminded the market of how new that asset class was.

We think several reasons explain the reversal: negative macro figures impacting the whole market; tourist money exiting the AT1 market; liquidity and shrinkage of dealers’ balance sheets; decent supply in the AT1 market; and last, but not least, idiosyncratic stories (BES).

AT1 have proven to be a very volatile asset class, and often the first asset class to be divested by investors in difficult times. A lot of investors without knowledge of the products have started trading these products. Those people have been the first to sell.

The whole BES debacle came as a surprise, but it taught the market a few things: in spite of the whole European supervision and regulation framework being put in place, events like that do happen again, and when they do, they have a significant impact on the AT1 market.

Ghislain Cortina, Boussard & Gavaudan: The birth of the AT1 market occurred in a very supportive environment for credit. Against that backdrop, AT1s’ unfriendly features were progressively dismissed as the primary market grew and attracted new types of investors principally driven by a hunt of yield.

Following the summer choppiness, AT1s experienced their first period of sustained risk-off sentiment. This was the first test for a still immature market and clearly the AT1s revealed their equity-like behaviour in more volatile environments. In addition, concomitant specific newsflow did not help improve sentiment: e.g. retail restrictions, BAML indices exit — not to mention less favourable supply/demand dynamics ahead of AQR, as well as the evolving regulatory framework (leverage ratios, TLAC, etc).

Robert Montague, ECM: There had been a lot of issuance, and if you have repeat issuers coming two, three times in a year or more, people get a bit full on them and so they want a pick-up to secondaries. If that’s not really there, they are going to say no. You are finding that unless it’s a new name, or it’s very attractively priced, deals are suffering. Until we had HSBC and Nordea, who were two new names — and also investment grade, which made a huge difference as well — investors were largely indifferent to the supply when it was just the same banks coming back to the market again.

You had BES in the summer, as well, which didn’t help sentiment, and obviously the closer you got to the AQR the more some people became a bit nervous. You also had the likes of Banco Popular and Aareal trying high trigger CoCos and some people thought — wrongly — that Popular would be a marginal pass candidate. In fact they passed quite comfortably, but people weren’t willing to take on an unrated high trigger AT1.

Brandenburg, Fidelity (pictured below): We found the HSBC deals attractive, simply because they are, in our view, going to be one of these low risk benchmarks for the sector as a whole, and I think they have done reasonably well. Nordea would fall into the same category, but their issuance volume is going to be far lower, so you don’t really have to take a view on them if you don’t want to, whereas HSBC is something you really need to add if you want to be exposed to the sector. So those went well.

As for Santander and the other euro deals, they looked pretty rich when they were priced.

We did see the size of books decreasing post-summer, while a purge took place in the secondary markets. Why was this?

Baud, BNP Paribas AM: Demand for new issues was very strong on the first CoCo issues, with books several times oversubscribed: from three times for the second tier Spanish bank Banco Popular Español AT1 — one of the earliest transaction in 2013 — to 14 times for the Crédit Agricole AT1 issued in January 2014, or even as much as 17 times for the AT1 of Danske Bank issued in March.

Books were not so strong post-summer, with only Eu3bn for Santander and Eu2bn for UniCredit.

We see several explanations for this weakness. Firstly, we must recognise that some new issues that came in September were expensive: Santander came at only 6.25%, after IPTs of the 6.375% area. Secondly, some technical pressures emerged, as Bank of America Merrill Lynch ruled that CoCos are no longer be eligible for high yield indices.

Thirdly, there is less appetite from retail investors. Asian retail investors, which were strongly committed to the very first issues, especially in US dollars, are less attracted by current yield, and seem more focused on forthcoming new issues from Asian banks. For the recent issue from Bank of China, private banks were 29% of the book, and investors were 94% Asian. For lower yield issues, the involvement of private banks was minimal: only 9% of the book for HSBC, for example, while Asia was less than 10%. Meanwhile, in the UK a ban was announced by the Financial Conduct Authority on retail investors buying CoCos from 1 October.

Finally, according to the Street, the weakness was exacerbated by fast-money investors who still weigh on the asset class by selling out at the first sign of macro trouble. Some hedge funds may also have unwound positions hedged with equity options.

Castelli, Method: As discussed, we see the sell-off as mostly determined by the same macro drivers that are putting pressure on the high yield market. In particular, the change in Fed monetary policy looks like the single most important cause. AQR in Europe has certainly been an additional source of concern, but the successful conclusion of the exercise will not, in our view, change the big picture, where negative drivers remain. Going forward, differentiation among US dollar and euro-denominated AT1 is likely, with the latter likely to find support from ECB monetary policy.

Harris, Old Mutual: It’s related to what I said before — ultimately it comes down to positioning. I doubt there was much paper sold in August and so the market was still pretty long. So when those guys reopened the market after the August wobble and the realisation that this was going to be a volatile asset class, the book sizes were a lot more realistic than those back at the start of the year when everyone was just grabbing for AT1 and risk. Maybe in May there was some padding of orders, but once it got to September I don’t think there would have been any padding at all, and that had a lot to do with the smaller order books.

François Gignoux, Eiffel: The volatility and the repricing that we have experienced since the summer have pushed investors to be more cautious when looking at the AT1 market.

The scarcity in liquidity proved that no matter the size of those instruments, it can get very hard to trade them. On a few days during the summer, it felt like a 5m clip of an AT1 was very hard to execute.

The BES fiasco did not help either: what would have happened if BES had issued an AT1 instrument back in June, instead of the capital raise they did? The repricing in the whole asset class would have been massive. That market is a nascent and untested one so far, and until it does get tested, the whole asset class will remain very sensitive to any adverse event on a financial institution.

The AQR has also been the main focus of attention in the last months, and this has probably prevented investors from adding risk in the AT1 space. We see the AQR and stress test as a positive catalyst for bank credit that should add transparency and liquidity to the AT1 market, as well as credit tightening over time.

Cortina, Boussard & Gavaudan: Technicals have been clearly less favourable. Besides the reasons stated above, continued heavy supply occurred whereas the investors base had not yet sufficiently stabilised. The summer volatility and lower liquidity might have pushed some types of investors to either exit the market or reconsider the size of their holdings. This was particularly evident when repeat issuers did not get much support, with limited incentives for investors to add on those names via primary versus secondary.

The secondary performance was disappointing, not only in absolute terms but also in the limited differentiation between names, circumstances, features. Essentially all AT1s indiscriminately behaved as a beta play echoing the broader market sentiment. This is not necessarily encouraging as a scenario of specific stress on the asset class (e.g. effective coupon cancellation) remains untested.

Dierk Brandenburg, Fidelity: It’s related to the supply/demand mechanics. Banks are very clearly incentivised to issue this debt, while on the buyside it’s not yet clear where the natural home for these bonds is. I think that makes people a bit wary of engaging with the asset class, whether they like the instrument or not. The question is: where do you properly price the supply relative to the funds that are available to be invested in it?

Meanwhile, after the summer there was this retail ban and then the index exclusion from the Merrill Lynch index at the end of September, which again meant that a lot of people found themselves overweight.

Hoarau, CA-CIB (pictured below): Book sizes dropped mainly because valuations were judged too rich and order inflation in primary almost disappeared. In the meantime, a lot of fast money investors, opportunistic buyers or low quality hedge funds simply quit the asset class during the purge. And as Michel pointed out, the demand from private banks in Europe as well as in Asia has also drastically diminished. Their contribution to the overall order volume pre-allocation was significant during the first half of the year. Most of the time inflated, it could easily reach three to four billion. You don’t see that anymore.

How much of an impact did the BAML index change have? 

Baud, BNP Paribas AM: Bank of America Merrill Lynch ruled recently that CoCos were no longer to be eligible for high yield indices. This change had a negative technical impact in the sector, as benchmarked investors ended up with off-benchmark positions that increased their tracking error.

However, we view this impact as limited and temporary: high yield funds are not natural investors for financial issuers and a number of high yield funds are benchmarked against non-financial indices.

In the long term, specific demand for AT1 should emerge from dedicated financial hybrids funds. We can notice that, following Merrill Lynch, Barclays has recently launched its own Global Contingent Capital index, which should help asset managers work on these projects.

Karsenty, Eiffel: The removal of AT1 instruments from the BAML corporate bond index may indeed have had an impact on the trading price of these instruments, but we believe that it was a healthy development. The inclusion of CoCos in broad indices brought in new money from investors that were not all familiar with the complexity of these products. AT1 are a nascent asset class and, as such, should be handled by knowledgeable investors, prepared for the underlying risk and volatility.

Castelli, Method: Like many other investors in this space, we do not follow a benchmark and our strategy was not impacted by this change.

Montague, ECM: It’s hard to say, because it happened in September when there was a lot of noise in the market. It’s easy to post-event rationalise, you know: blame the index, blame that. But there were lots of other things going on, negative macro news as well, the geopolitical situation with Ukraine and the Middle East. So it’s very difficult to pin it on that totally, I’d say. There might have been some effect, but it’s hard to split out the various causes.

Are current valuations and relative value metrics interesting?

Gignoux, Eiffel: Compared with a couple of months ago, valuations of the newly-issued AT1 instruments look attractive. On average, they currently yield 6.5% (Z spread of 515bp), more than 1% above their lowest yield reached in mid-June this year. In terms of cash trading price, they have on average recovered 3 points from their lows reached in mid-October, but are still trading 6 points below their June highs.

We have a constructive view on the banking sector. Banks raised a significant amount of capital ahead of the ECB AQR and EBA Stress Tests. For instance, on a fully-loaded basis, only one AT1 issuer would have breached its conversion trigger at the end of the stressing period in the adverse scenario (i.e. 2016 Adverse Fully-loaded CET1 ratio < AT1 trigger). The AQR/stress test results thus give us comfort on the fact that conversion risk of AT1 is remote.

One of the major caveats, however, remains the AT1 instruments’ volatility, which undermines their attractive returns.

Pettersson, SEB: After the massive sell-off since the beginning of the summer, spreads have started to look attractive again. Supply will continue to be an issue, as it will put pressure on secondary market trading. However, even without spread tightening, the AT1 market offers a nice carry which is not that easy to get these days.

Harris, Old Mutual: It’s certainly getting there. It’s a lot more interesting than it was, put it that way. You’ve only got to look at the CoCo index and it’s as low as it has ever been. That’s not to say that it couldn’t go a little bit lower. But it’s certainly looking more interesting.

We’ve obviously got some concerns around European growth, but I don’t think that’ll be enough to lead to coupon deferrals on AT1 or anything like that.

Cortina, Boussard & Gavaudan: The repricing since the summer has clearly created opportunities in the AT1 market. However, in an overall more cautious and volatile environment, AT1s have proved to be very macro and market sentiment-driven instruments. Also the risks of heavy supply are likely to weigh on overall valuations: the highs of between May and July might not be reached again in the near future unless the broader market and macro sentiment were to change dramatically for the better.

Given the high correlation within the asset class, we feel the market is still too young to put in place efficient fundamental relative value strategies within the space. Having said that, some opportunities exist, especially on the instruments issued by names that have positively surprised in the ECB stress tests. Some of these holdings can be efficiently hedged with other asset classes like stocks or even to some extent new sub CDS contracts. In addition, the market correction has been indiscriminate between duration and structures: given the first wave of issuances of perpetual non-call five structures were issued in the second half of 2013 with a very high back-end (hence a very high probability of call) we believe that shorter call AT1s with low triggers deserve to be less volatile and to trade at a much steeper spread curve versus longer dated call structures.

Baud, BNP Paribas AM: We are positive on AT1 at current levels. The Asset Quality Review and Stress Tests published on 26 October were an important step for banks. All major European banks passed, which should reassure investors in the near term.

Third quarter results were positive for most banks: at Deutsche Bank, the Common Equity Tier 1 ratio was 11.5% at the end of the third quarter, on a fully-loaded CRR/CRD IV basis. This ratio was 10.2% for Barclays for the same period, an advance compared with 9.9% at the end of June and good progress towards its 11% 2016 target.

We believe that hybrid securities can be seen in a good light: as of 28 October, Contingent Capital securities can provide an average yield of 6.18 % according to the Barclays index (82 securities) and 5.97% according to the Merrill Lynch index (76 securities), with an average rating of mid to high double-B, and an average duration of 4.97.

This really provides an attractive pick-up compared with the rest of the capital structure. Bank subordinated (83 securities within the Barclays Euro Investment Grade index) show an average yield of 2.03%, with an average rating of mid to high triple-B, and an average duration of 4.56. The average yield for the Merrill Lynch Euro Subordinated Financial index (188 issues, also restricted to investment grade, but including insurance and financial companies) is 2.38% for high triple-B ratings on average and an average duration of 4.67.

Are all of the structural elements correctly appreciated? What are your priorities when evaluating AT1 instruments?

Harris, Old Mutual (pictured below): This element of the market is quite well understood. I don’t come across many investors who have no idea about the intricacies of MDA language and that type of thing and are just investing in AT1 blind — although anecdotally you hear that maybe there are some.

For me, it’s credit fundamentals that are an absolutely number one priority. That is absolutely paramount when investing in an AT1. The structure of a bond is secondary.

Take a very strong issuer like HSBC, for example, it has a 7% fully-loaded trigger, it’s one of the tightest trading names, and that’s because it’s an incredibly strong institution, whereas if you look at Barclays, it’s again got a 7% fully-loaded trigger, but it trades much wider because it is much weaker. So it’s credit fundamentals first and structure second. And then things like issue size are again further down the list.

Pettersson, SEB: Before we get too distracted by technicalities, we need to remember that the most important thing is first and foremost our credit assessment of the issuing bank. The second step is to evaluate the structural elements but also the technical picture in the market. Lastly, we add our relative value analysis to decide if it is a potential buy.

Baud, BNP Paribas AM: CoCos are complex instruments that require more detailed analysis than standard bonds. The starting point of our analysis is the classic fundamental credit analysis of the issuer. In addition, for such securities, it is key to review the structure of each bond. We analyse the risk of hitting the trigger (dependent on the solvency of the bank and its risk profile), the risk of non-payment of coupons (for AT1 CoCos, coupons are discretionary, but cancellation could become mandatory below a certain level), and all other relevant items (loss absorption, jurisdiction risk, the risk of modification of prospectus under tax or regulatory events…).

The distance to trigger is our first metric for quantifying the risk of such securities. AT1s are usually classified under “low” or “high” trigger, but this is not so simple: some bonds are coming with a “dual trigger” structure, like Crédit Agricole, with a low trigger at the issuing entity (CASA), or a high trigger at the group level — which needs be analysed in view of intra-group guarantees.

Furthermore, the transition into Basel III adds to the complexity: the distance to trigger under Basel III phase-in could be different to the Basel III fully-loaded ratio. Besides, expected ratios need to be extrapolated for future years, especially during the transition period: those projections until 2019 require several hypotheses, like the internal capital generation. Finally, the probability of an adverse scenario should also in theory include the Point Of Non-Viability, which is even more difficult to quantify.

The coupon risk can be measured by the distance to mandatory coupon restriction. This is a significant risk that is probably underestimated by market participants; however it is not an immediate concern, as a transitional regime will be in place between 2016 and 2019. As a result, distances to mandatory coupon restriction are high until 2016 and are then progressively reduced by the progressive inclusion of the capital conservation buffer and G-SIB systemic buffers. For instance, for Crédit Agricole, a distance to mandatory restriction of 7.5% is projected until 2016.

The loss absorption language in the event of the trigger being breached also requires investors’ focus: the language could be more investor friendly, with partial and temporary write-down of the principal, or conversion into equity, rather than a permanent full write-down. For temporary write-down, in case of return to financial health, a gradual write-up could then occur under certain conditions (positive consolidated net income, subject to minimum distributable amount), at the issuer’s discretion. However, since those instruments have not yet been tested, it seems that market participants are more focused on the frequency (i.e. the probability of reaching the trigger), rather than the severity (potential recoveries after a breach, which is expected to be a remote risk).

Quantifying each of the risks listed above and pricing such a security accordingly is not easy. As CoCos are complex securities with embedded options, it is complicated to tackle their valuations in a straightforward way. Some market participants have developed “in-house” tools, but there is no unanimously recognised standardised pricing methodology.

Cortina, Boussard & Gavaudan: They are not, but admittedly there are still lots of new or moving parts that are still very hard to appreciate or even quantify: Maximum Distributable Amount, Available Distributable Items, combined buffers requirements, Point Of Non-Viability, etc.

The market was also hoping for some standardisation of structures under Basel III: however, we have to live within a still evolving regulatory environment and national discretions. Hence AT1 is actually a very broad and generic concept bringing together various types of instruments (gone/going concern).

Investors have to accept the features of AT1s such as fully discretionary coupon cancellation, the possibility of write-down and bail-in. Hence, fundamental work is key to the investment decision, especially with regard to loss absorption risks: the ability to predict buffers to trigger can vary a lot according to the business mix of the issuer, its RWA profile, its national regulatory environment, and its strategic priorities. The risks of coupon cancellation certainly have a much higher probability of occurring, but remain harder to quantify at this stage. On that front, some companies are more exposed to one-off hits like litigation risks or provisioning adjustments than others.

Castelli, Method (pictured below): First of all, we have to admit that we find it difficult to evaluate AT1: all CRD IV-compliant bonds are perpetual with a pure discretionary coupon. From a purely legal perspective, there is nothing preventing issuers from transforming those claims into a perpetual zero coupon bond (in this case, the value would collapse to zero for bonds with a write-down/write-up mechanism, or to the premium of a digital option on CET — struck at the conversion trigger — for structures with a convertibility feature). This scenario is, in our view, completely undervalued by the market, and we find this quite remarkable, especially for those of us who still remember the day, less than five years ago, when a large bank decided to skip a call on a Lower Tier 2 security on “economic grounds”.

Basel III bonds with a dividend stopper clause are a much more palatable proposition.

Karsenty, Eiffel: We think that as of today, not all structural elements of AT1 are correctly appreciated by investors. For instance, the pricing differential between two products with different conversion features is particularly difficult to assess (for example, equity conversion feature versus temporary write-down). This is especially true in the current environment where conversion risk appears relatively remote, as banks and especially AT1 issuers have taken significant measures to reach relatively high solvency ratios. We do, however, believe that pricing differentials could reappear in times of stress (e.g. solvency closer to trigger level on given names).

We therefore favour “credit-friendly” structures with higher prospects of recovery in the event of conversion and prioritise equity conversion features over write-down (temporary or full).

Regarding structures, has anything caught your attention?

Brandenburg, Fidelity: I would pick out three things.

Firstly, the use of AT1 for the leverage ratio, and what structures will be required for that. We’re quite keen to know how the regulators see AT1 evolving, if it’s to be used to finance the leverage ratio rather than just the 1.5% risk-weighted assets bucket.

I would also pick out the issue of management buffers. If you look at the ECB stress test, it gives you a good idea around sort of what the downside is for banks. We talk to management teams and they still think they need to run management buffers of 50bp or 100bp above the minimums set by regulators, but for a lot of AT1 issuers that is maybe too small.

And then if you look at the stress tests, most of the triggers are well out of the money, because even under those scenarios none of the loss-absorbing features would have been triggered. So in that respect, I get a sense that the regulators are probably going to move away from these 5.125% triggers and up to triggers of at least 7% — we have seen that with some of the issuance out of the Nordics, which has come with 8% triggers. And then you also have some voluntary 7% issuers, like Crédit Agricole. And overall we see that shifting up, because otherwise the triggers are not really worth a lot, right?

Low trigger versus high trigger: to what extent does this matter to you?

Pettersson, SEB: We need to ask ourselves: is there a conceptual difference in the mind of regulators between a low trigger and a high trigger bond? If a bank gets into severe problems, is it easier for regulators to force a conversion of a high than a lower trigger bond? If the answer is yes, the distance between actual capital levels and trigger levels is the most import factor. If no, we should focus more on absolute capital ratios.

Cortina, Boussard & Gavaudan: It matters, even more now that companies will be regularly tested on stress test scenarios assumptions. While you could assume that from a coupon cancellation risk standpoint both instruments are aligned, high trigger instruments are going concern instruments whereas low trigger ones are gone concern. It makes a lot of difference in many circumstances. One could argue that both instruments are subject to Point Of Non-Viability language and that under such a scenario, this point of non-viability would not be far from a high trigger in some jurisdictions. However, having a contractual high trigger is clearly much more restrictive. This is particularly true for those names potentially exposed to one-offs hits (e.g. litigation risks) or for smaller issuers.

As a consequence, it is also difficult to envisage a high trigger structure without equity conversion features for most issuers.

Castelli, Method: Distance to trigger is, according to our structural (fundamental) models, one of the most important drivers of valuation. Looking at our reduced form (trading) models, other market participants seem to share our view.

Gignoux, Eiffel: One could argue that you are better off holding the low trigger instruments, but we have a tendency to focus on buffer to trigger over the trigger level itself.

It is not a static picture that we assess, but we try to assess organic capital generation as well as earnings volatility, when looking at the AT1 market. This approach remains the same for the distance relative to the coupon distributions.

So ultimately we are more or less indifferent to the trigger level itself.

What matters the most: issue size, spread, credit or loss-absorbing metrics?

Baud, BNP Paribas AM (pictured below): Yield appears to be the prime reason why investors buy CoCos. The historic performance of CoCos was still good this year, despite the repricing seen since this summer — the total return has been 4.64% year-to-date, according to the Merrill Lynch index. Current yields are attractive, at 6.18 % on average, according to the Barclays Global Contingent Capital index.

Credit and loss-absorbing metrics should be carefully analysed on a case by case basis, according to the factors I mentioned earlier.

Karsenty, Eiffel: We look at all those metrics but our priority goes to the credit. This is the key parameter that will drive whether or not we invest.

In a second step, we look at other parameters: structure, call period, reset type, currency, spread, issue size, etc.

Cortina, Boussard & Gavaudan: A combination of them all, to be honest. For the largest issuers, the pace of issuance and new issue premiums will increasingly matter, too.

Castelli, Method: Issue size does not seem to be a relevant differentiating factor in a world where most issuers go for benchmark size. It would certainly start to matter with smaller issuers coming to the market.

By the way, illiquidity premium is certainly an issue for the whole fixed income market, but “benchmark size” is apparently offering very little help, so I am very curious to see how the “steepness” of the liquidity curve evolves going forward.

What can you say about the spread differential between Tier 2-hosted CoCos and AT1? Is the value of the deferral element correctly priced in?

Castelli, Method: At the beginning of the year, our models were telling us that deferral risk was mostly overlooked. In recent months however, we saw a shift, with market pricing starting to reflect MDA metrics. Having said that, there are only a limited number of issuers where the full capital structure is available (CoCo and AT1 issued by the same issuer) and where available, triggers are generally different. This makes comparisons a bit tricky, with too many variables to be estimated from a limited number of known variables

Pettersson, SEB: Deferral is one of the main risks embedded in AT1 instruments, but our assessment is that current valuations compensate you well for that risk.

Cortina, Boussard & Gavaudan: One comment is that market size and supply dynamics are going to be very different as the market grows: most banks will be issuing AT1s, whereas Tier 2 hosted CoCos will likely be useful in only a few jurisdictions.

Hoarau, CA-CIB: With supply and volatility increasing, I think the size element — and frequency of appearance — will gain in importance when doing due diligence, providing that the investor feels comfortable with the credit profile of the issuer and the features of the AT1. I have the feeling that more and more portfolio managers weigh the size more than the price element when they gauge the potential for spread performance. A smaller size is a strong contributing factor to relative stability during periods of turbulences. Danske Bank printed Eu750m in PerpNC6 format in May and the bonds have outperformed its peers by far. On a curve-adjusted basis, its AT1 is the only non-investment grade security to trade below the 5% mark in the five year segment.

You are invested across formats in subordinated debt, between bank AT1/Tier 2 and sub insurance — where do you see most value taking into account risk, the profile of the issuer and current valuation levels?

Cortina, Boussard & Gavaudan: We are indeed invested across formats: AT1, vanilla Tier 2 banks, legacy instruments, as well as insurance subordinated bonds. The market has been very focused on AT1s this year as the new fashionable nascent market, but some of the more interesting opportunities have been rather coming from more investor-friendly structures issued either from lesser known banks or higher betas issuers in credit-normalisation mode.

We also like insurance subordinates where the emphasis has also been on deleveraging and balance sheet strengthening ahead of Solvency II — as in the banking sector with Basel III, but with much less event risk (e.g. AQR, litigation risks, etc.). The language in the prospectuses of bonds currently issued by insurers are among the most bondholder-friendly structures in the hybrid space. We particularly favour Solvency I structures recently issued by higher betas names, especially after the market sell-off in September.

Brandenburg, Fidelity: Regarding Tier 2, a lot will depend on the TLAC requirement, which looks very onerous to us, in the sense that lots of banks have to issue multiples of the supply they already have out in the market. That makes Tier 2 slightly less attractive because of the uncertainty. Although ultimately Tier 2 is in the index, so if it gets issued, people will buy it.

And then on AT1 we find the picture a bit clearer, with the sort of caveat of the leverage ratio requirement. So I would say AT1 looks marginally more attractive — also given where yields on them are at the moment.

Pettersson, SEB: We like the subordinated segment in general. We appreciate the strong improvement in credit quality that the banking sector has achieved — more and better capital, less dependence on short term financing, larger liquidity buffers, etc. OK, government support is something that we can’t count on anymore, but we have never invested in banks based on the premise that they will be bailed out by the state if something goes wrong. The insurance sector, on the other hand, has been quite stable throughout the crisis.

What we like within subordinated debt is more based on relative value and will differ from time to time. Lately we have noticed that the sub insurance sector has underperformed the rest of the investment grade market and become increasingly attractive.

Baud, BNP Paribas AM: As explained earlier, we are positive on AT1 at current levels.

On Lower Tier 2, even if the fundamental are still supportive, we think we may see some technical pressure in the near term. Total Loss Absorbency Capital ratios may lead banks to issue Lower Tier 2 instruments.

As far as insurance is concerned, we still like the sector for its fundamentals, with a preference for non-life versus life due to the low yield environment, but liquidity (which could be low for some bonds) should be taken into account for each bond’s risk/return profile. We are more cautious on long dated Upper Tier 2 and see tactical value on short dated Tier1: as demonstrated in the Axa exchange, insurers are expected to benefit from Solvency II transition rules in the coming month, as the window for grandfathering Upper Tier 2 into Tier1 will close in 2015.

Harris, Old Mutual: Insurance sub, particularly in sterling, does tend to trade cheap to banks, and I don’t think that’s quite right, because fundamentally the health of the insurers is very good. They are still carrying excess capital into the introduction of Solvency II. Although some of the UK insurers in particular have got some earnings headwinds, given the amount of capital they are holding I don’t think it materially changes the fact that they have still got relatively strong balance sheets, so I kind of see sterling sub insurance as pretty cheap.

Castelli, Method: Recent changes in regulation have contributed to a widespread repricing of anything with a CoCo label. While we share regulatory concerns regarding retail investors, we find preventing the purchase of Credit Suisse or HSBC CoCo bonds (just to mention some of the highest quality bonds we have in mind) odd while the same client can continue to buy HAA subordinated (not to mention shares in peripheral banks). Anyway, we like regulatory anomalies when they create opportunities: in this case, they sparked heightened risk aversion in the investor base, with Lower Tier 2 CoCos moving from expensive to outright cheap with respect to perpetual AT1s. Basel III AT1s with a dividend stopper feature, although rare, are another area where we see good value.

Perpetual issuance from insurance companies is another investment theme we like: it enables us to add diversification while enjoying the protection of Solvency I structures with little mention of explicit bail-in features.

We see bank Lower Tier 2s as less compelling (with a few distressed exceptions): Lower Tier 2s have a more stable investor base that seems to underestimate the risk of statutory bail-in (or, more likely, benchmarking and regulatory constraints prevent a large part of the investor base from switching out of Lower Tier 2s into CoCos).

Gignoux, Eiffel (pictured below): As previously mentioned, we have a constructive view on European banks. We selectively favour AT1 over Tier 2 instruments as they offer higher upside potential, in a sector where issuers are managed in the interest of their creditors. In addition, the recent discussions on Total Loss Absorbing Capital buffers (TLAC) for systemic institutions could also force banks to issue significant amounts of Tier 2 capital, which would provide a negative technical for this asset class. Given the recent AT1 volatility, we lean toward investing in lower beta instruments issued by defensive credits.

The picture for the insurance sector is slightly different. Insurance companies are not as incentivised as the banks to take credit-friendly actions. They are less scrutinised by investors and the regulatory environment remains benign for now. Solvency II, the new prudential framework, will be more stringent for insurers, but its application is scheduled for January 2016 and the transitional rules appear relatively generous for issuers. We do, however, see value in some recovery stories within the European insurance sector.

Is there much room for much higher beta issuers?

Montague, ECM: Yes, I think so. There’ll certainly be a better reception for some of the borderline names. I’m sure some of those who couldn’t issue ahead of the AQR will dust down their previous projects and come to market.

If things are priced correctly we will consider them. But obviously it’s more than price; it’s the name, the structure and the kind of environment we are in.

Harris, Old Mutual: I think these guys can come to market, to be honest. They will have to really pay up. But the thing is, even in the low double-digit yields, it’s cheaper than the cost of equity because of the tax-deductibility of coupons. If you think your coupon comes down by 30% compared with the cost of equity, it still probably makes sense for, say, second tier Italians that have comfortably passed the AQR or the Spanish to come at 10% if they need to. Popular came at 11.5%. And I think there’ll probably be a market for that at that type of yield at the right time.

But I do have, let’s say, wider concerns about the amount of through-the-cycle holders of AT1, the type of holders that hold on to the bonds come rain or shine. I think the asset class is just going to remain volatile because I don’t see there being enough through-the-cycle holders — everyone’s willing to trade this asset class. As I mentioned before, these are big liquid issuances, and they will continue to be volatile, frankly, especially versus the amount of issuance that is needed. But that’s not to say that we can’t have second tier, high beta issuances if they come at the right price.

Castelli, Method: For the moment, high beta names are likely to remain a rare opportunity: as we saw with Popular, there may be some special situations where an issuer will be happy to pay double-digit yields instead of diluting shareholders. But this is likely to remain an exception rather than the norm.

Karsenty, Eiffel (pictured below): It looks to us like most issuances will be coming from the higher quality banks, as institutions that are in some form of restructuring will be incentivised to wait to see an improvement in credit costs to issue these types of yieldier securities. But we do expect some non-core banks to come and tap the AT1 market.

Cortina, Boussard & Gavaudan: With regards to higher beta issuers, we believe there is a market for them! However, only at the right price, right size, right structure and more importantly pace/size of issuance. Timing is important as well, as investors need to feel the issuance is coming from a position of strength rather from a company potentially being forced to issue. Back in October 2013, Banco Popular was actually the first issuer to open the euro AT1 market with a Eu500m unrated low trigger issuance. Since October 2013, their credit story improved, with concrete catalysts for an improvement in their capital metrics (e.g. equity placement, treatment of Spanish DTAs, various disposals). However, the timing of their attempt at a high trigger issuance this summer a couple of months ahead of the AQR results was certainly not optimal as it wrongly raised doubts in the market about their ability to pass the stress tests.

Generally speaking, the AQR exercise and subsequent better disclosure and harmonisation of metrics such as NPL provisioning should also help the investor community to fundamentally better appreciate the resilience of the buffers and risks around coupons cancellation.

How much supply can the market absorb going forward?

Cortina, Boussard & Gavaudan: Regarding better credits, looking back at this year’s activity, especially September’s issuances, there was a clear discrepancy between the market appetite for very frequent issuers versus newcomers. Those multi-time issuers might have been too optimistic about the ability of the market to absorb a new issuance nearly every quarter on the same name on such junior structures in what is still a very young market.

Gignoux, Eiffel: The market has been struggling to digest the recent issuances — although one can argue that the AQR process and the recent repricing have made the market look safer and attractive again.

Castelli, Method: Our view is that the market has still to overcome its niche nature. We still do not see any “natural” buyer, apart from a few specialised funds like the one we manage.

“Seed money” for the asset class was apparently provided by a mixture of opportunistic investors (hedge fund/total return types) and non-European private banking; a second wave appears to have materialized from HY fund manager s. While this money is certainly welcome, filling a gap in institutional demand, it is far from a stable and committed investor base. As proved by the limited number of euro-denominated transactions, local demand is still very small with respect to the issuance plans announced so far.

Given this lack of structural demand, 2014 issuance will be certainly difficult to beat, especially in a weak environment for the High Yield market.

Baud, BNP Paribas AM: Investment grade funds are increasingly looking at these bonds for diversification. However, allocations to such instruments will remain limited, as the bonds are off-benchmark and mainly high yield.

Insurers are currently almost not involved in the asset class due to their regulatory constraints (only 4% of the book for Danske Bank, and 2.5% for UniCredit).

In the current environment, there is a real opportunity for new funds dedicated to financial subordinated bonds. Asset managers are currently working on such projects: in our global credit team, we have in October launched a mandate dedicated to global hybrid securities for one of our clients.

Besides, it is worth mentioning that higher beta issuers could also rely on highly yield-sensitive retail investors, as demonstrated by the new issue of Bank of China. With a yield close to 7%, investor appetite was strong. Total orders were as high as $21.8bn. In term of investors, Asian retail and sovereign wealth funds comprised the majority of the book (in total, Asian investor were 94% of demand).

In the UK, the ban announced by the Financial Conduct Authority on retail investors directly investing in these complex instruments demonstrate the need for fund managers’ expertise.

Montague, ECM: The investor base has grown reasonably well. Some people have adjusted their mandates and there are new funds being set up.

Issuance has been fairly strong. Including exchanges there has been $55bn, and even if you strip out exchanges — which are a sort of captive issuance — you still have over $40bn, which is a chunky number, and there’s room for another few billion before year-end. So it’s been pretty healthy — even considering how little there was after the summer.

You’ve had the regulators getting worried about retail involvement, particularly in the UK. To be honest, I don’t think UK retail were that heavily involved. It’s a red herring because the minimum size on most of these deals is £100,000 or £200,000 clips, and how many retail investors have got £200,000 to put into one issue? That’s a high net worth individual territory. It’s a private banking investment, really, and those are a brought under the umbrella of professional investors. So I don’t really think that’s a huge issue.

Brandenburg, Fidelity: We expect the investor base for the instruments to develop. It’s just a question of how quickly this will happen, and on the issuer side it went a bit too fast. But it’s just a question of pace — the direction of travel is clear.

Hoarau, CA-CIB: I agree with Dierk, but I fear that supply will increase quicker than the investor base in the short term. We need more buy and hold accounts, more dedicated CoCo funds and less fast money and opportunistic buyers if we want the volatility of the asset class to decrease. Looking at the profile of demand globally, I am concerned by the evolution of the investor base in Germany, which is virtually non-existent, and the lack of support from the German regulators.

What are your expectations for 2015?

Harris, Old Mutual: In terms of volumes, I expect them to be somewhat similar, if not exceed this year. Now, that’s obviously highly market dependent. If markets settle down and we go back into a hunt for yield mode, then that could drive another rally in AT1, which in turn would probably drive more issuance. But there’s that question mark over through-the-cycle holders. And now that the Emperor has cast off his new clothes, and we know how volatile this asset class is probably going to be in the future, that could check somewhat the ability of the market to take this stuff down. But over the course of 2015, yes, if banks are willing to pay up there will be a home for it.

Cortina, Boussard & Gavaudan: 2015 will certainly be an interesting year for the AT1 market. We do not think it will be the year when features (loss absorption, coupon cancellation) come to be tested, especially with MDA kicking-off in 2016. The test will rather be again on supply/demand dynamics, particularly in those jurisdictions still to issue their inaugural transactions.

Hoarau, CA-CIB: The profile of supply will evolve in 2015, with a solid contribution coming from higher beta names, mainly from southern Europe.

Elsewhere, Dutch issuers will make their debuts early in 2015 after having received the official green light from the regulator to issue AT1. Until now the Netherlands had to wait for a law allowing AT1 coupon payments to be tax-deductible and freeing banks from withholding tax on interest payments. ING, Rabobank and ABN Amro are all expected to issue during the first quarter of 2015 — the three banks reported a combined risk weighted asset total of around Eu600m at the end of the third quarter. This implies around Eu9bn of potential AT1 issuance. Austria, among others, has yet to make this clarification.

Elsewhere, Solvency II-eligible subordinated capital transactions for insurers will very likely emerge in 2015.

Last but not least, TLAC, ALAC, MREL or rating agencies’ recent moves still need to be fully digested, but all will massively impact supply in subordinated format and lead to a substantial increase of Tier 2 offerings. This will weigh on bond performance and the overall spread situation in Q1 2015.

Montague, ECM (pictured below): The banks will want to fill their 1.5% AT1 bucket first, and then the question is whether some names will go beyond that because they’ve got leverage ratio issues. Absolute yields remain low, these instruments are quite attractive from an issuer perspective given where the cost of equity is for some of these banks. Good quality banks are issuing with coupons of the high 5s, low 6s, and the cost of equity is north of that, 8% or 9%, and then you have the tax saving on top of that. Ultimately whether total issuance reaches the same level as this year or surpasses it will be very dependent on market conditions.

Castelli, Method: We see the risk of issuers being unable to meet their AT1 issuance targets: high quality issuers, especially the ones able to achieve solid ratings, will do better, while smaller/weaker issuers will be met with scepticism.

We do not expect the US dollar HY market to recover anytime soon: issuers will be then forced to pay a premium with the whole ML CoCo index repricing 50bp wider in 2015. Repricing is likely to be more contained for euro-denominated AT1s/CoCos, where the market is already requiring a hefty (and somewhat unjustified) premium.

With a 50bp widening and a further 50bp increase in US Treasury rates, US dollar bonds likely to offer a limited, although positive total return. We forecast a much better outcome for euro-denominated bonds, with stable risk free rates and a more manageable 35bp widening in credit spreads. Our expected return for US dollar denominated securities is 0.50% in local currency, increasing to a much more attractive 4.25% for euro-denominated bonds. This should help broaden the local investor base over time.

Karsenty, Eiffel: 2014 has been a critical year for the nascent AT1 asset class. At the end of 2013, eight new-style instruments amounting to only Eu8bn had been issued. Today, more than 40 instruments are actively traded, representing over Eu50bn outstanding.

Excluding a few high profile accidents such as the BES/Novo Banco situation, 2014 has seen positive developments for banks creditors, with improving solvency ratios and issuer transparency. We expect the same path to be followed throughout 2015, with banks focusing on the quality of their core capital (i.e. replacing phased-in with fully Basel III-compliant capital), hence improving issuers’ solvency. Issuer transparency should also improve with yearly stress tests now being mandatory for all major European banks.

At the same time, the technical picture for AT1 instruments will remain challenging, as several issuers will come to the market. This additional pressure should limit any material tightening in AT1 credit spreads.

The compelling AT1 carry and European banks credit-friendly behaviour should, however, continue to provide attractive investment opportunities throughout the coming months.