Demystifying equity and AT1 correlation

Among the fundamental characteristics intuitively attributed to a hybrid instrument, a correlation with related equity performance is one of the most oft-cited. But while a strong correlation with share prices may appear fairly natural and logical, does it really occur? Szymon Wypiorczyk in Crédit Agricole CIB’s DCM Solutions cautions against jumping to conclusions.

Prior to 2020, correlation based on price indices of bank and insurance equity, and of related subordinated instruments fluctuated significantly throughout 2018 and 2019. The evolution of their dependence was quite random, with correlation remaining relatively weak and no signs of any strong convergence between different instruments and asset classes. We believe that in spite of the many equity characteristics of hybrid instruments, the performance of the hybrid market was mainly driven by fundamental credit metrics and central bank measures, and typical equity KPIs already had a limited impact on subordinated debt. During this period, European financial institutions (FIs) were in at least decent shape, even if their low profitability — primarily provoked by an inhospitable, low interest rate environment — was already a reality. Stable economic growth and the significantly improved or sound asset quality of the majority of institutions allowed subordinated investors to sleep easy.

Over the past few months, we have observed an interesting change in the relationship. At the beginning of the year, a substantial increase in correlation could be observed, with a visible and strong convergence across subordinated instruments for both asset classes. We believe that this change was mainly driven by the gradual advance of Covid-19 and particularly accentuated by the World Health Organisation’s declaration of a pandemic and following lockdown decisions in major economies. Plummeting global markets provoked a similar reaction in financial institutions’ subordinated instruments, but subsequently the situation has changed considerably.

Bank and Insurance Subordinated Instruments and Equity: price evolution (since January 2019)

iBoxx 1 June a

Bank and Insurance Subordinated Instruments and Equity: correlation coefficient (since January 2020)

iBoxx 1 June b

Key takeaways:

● A substantial rise in the correlation at the beginning of the year — the correlation coefficient reaching the range of 0.85-0.95 for all analysed asset classes
● A gradual decrease of correlation since the Covid-19 outbreak — particularly by Bank Tier 2 (a drop from 0.80 to ~0.1)
● AT1 and RT1 instruments exhibit a very similar behavior in terms of correlation evolution in 2020

Source: Crédit Agricole CIB — see notes below for further details

Since late March, we have witnessed a gradual weakening of the correlation for all analysed asset classes. This phenomenon could in part be explained by all the protective measures announced by the European authorities (reduction of capital and liquidity requirements) and their recommendation that basically forced banks to shore up capital with dividend cancellation (on 27 March the European Central Bank asked banks not to pay dividends or buy back shares during the Covid-19 pandemic until at least October 2020, with a similar statement from Eiopa on 2 April), but also by a strong statement from Andrea Enria, chair of the ECB’s supervisory board, on 8 April: “ECB has no plans to order banks to suspend coupons on their hybrid debt.” Those actions were supposed to help banks and insurers to maintain crucial access to the subordinated markets in an extreme context where equity markets are closed.

Today, this strategy seems to be working. All the capital relief measures and especially the dividend cancellation recommendation mechanistically improved FIs’ credit metrics that again seem to be a major factor for the subordinated market. Consequently, we have seen a dichotomy in equity and fixed income interests.

An interesting observation is the very similar behaviour of AT1s and RT1s — their correlation with the respective share prices came out very similarly, showing that these instruments are perceived very similarly by investors.

Another interesting point is an even more important decrease of bank Tier 2 and equity dependence in recent weeks. The ECB’s statement on AT1 coupons may have been perceived as very strong and reassuring for the interests of AT1 investors, but at the same time the statement has implicitly reduced Tier 2 bonds’ risk and incited an outperformance of Tier 2. Such favourable conditions allowed Commerzbank and Crédit Agricole to execute very successful Tier 2 transactions last week (see related articles).

Even if the correlation between subordinated instruments and equity can be perceived as a quasi-paradigm, we need to be careful before jumping to conclusions about its relevance. We consider that, in today’s opaque and extremely complex regulatory context, other, less straightforward factors weigh on the performance of the subordinated market, even if our perception may be biased by its behaviour during the crisis.

Note: The correlation has been calculated based on the following indices:
Europe Banks Stoxx Index SX7P — as a proxy for European Banks Equity market
STOXX Europe 600 Insurance Price EUR — as a proxy for European Insurance Companies Equity market
Barclays Europe CoCo Tier 1 I31415EU Index — as a proxy for AT1 market
Barclays Tier 2 Index — as a proxy for Tier 2 market
RT1 CACIB Index — in-house based on selected European RT1 instruments
The evolution of correlation presented on the second of the charts is based on 30 days correlation