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Glossary

AT1 Bonds

Category — Bond Types
By Konstantin Vasilev Member of the Board of Directors of Cbonds, Ph.D. in Economics
Updated October 23, 2023

What is an AT1 bond?

AT1 Bonds, also known as Additional Tier 1 Bonds, serve as capital instruments that banks utilize to augment their core equity base. Unlike conventional bonds, AT1 Bonds are perpetual and thus, the investors are not paid the principal amount. Their primary purpose is to secure long-term capital for the issuing banks.

The significance of AT1 bonds was further emphasized during the global financial crisis, as certain banks faced precarious situations that left them scrambling for government-funded bail-outs. As a result, AT1 bonds have become an integral tool for banks to maintain stronger balance sheets and absorb losses, providing a safety net during periods of financial stress.

AT1 Bonds

How do AT1 bonds work?

AT1 bonds function as hybrid instruments that offer attractive yields, particularly during favorable economic conditions. Similar to high-yield bonds, they provide investors with steady interest payments. However, their unique feature becomes apparent when specific trigger points are met, often linked to the bank’s capital levels concerning its assets.

During challenging times, if the bank’s capital falls below specified levels, the AT1 bonds fall under an automatic conversion into equity. This conversion results in a reduction of the bank’s debt and allows the bonds to absorb manage losses. Essentially, this mechanism helps to improve the bank’s capital position and provides a safety net during periods of financial stress.

The importance of AT1 bonds was realized following the global financial crisis. Examples from Credit Suisse and Deutsche Bank demonstrated the need for European banks, including Swiss private banks, to strengthen their capital positions to avoid situations that had left other banks searching for government-funded bailouts during the crisis.

AT1 bonds, also known as contingent convertibles, found keen buyers, especially among institutional investors and ultra-wealthy clients of private banks. These hybrid bonds provided an attractive investment option for those seeking higher yields, while banks benefited from issuing them to reinforce their balance sheets.

The Basel III norms introduced by European regulators emphasized the importance of loss management, putting junior bondholders on notice that they could face write-downs in particular circumstances. Credit Suisse’s deal caused fury from some bondholders who felt they were unfairly paid, leading the government, taxpayers, and other banks to be wary of similar situations in the future.

Why are At1 bonds risky?

AT1 Bonds are considered risky investment options for several reasons:

  1. Lack of Redemption. Investors cannot sell or redeem these bonds to the issuing bank, which means they are tied up in the investment until certain conditions are met.

  2. Call Option. While investors cannot redeem the bonds, the issuing bank has the option to redeem the AT1 Bonds after a specific period, potentially cutting short the expected investment duration for the investors.

  3. Interest Payment Uncertainty. A significant risk with AT1 Bonds is that if the issuing bank faces institutional failure or its capital ratio falls below a certain percentage during a particular year, it may reduce or entirely withhold interest payments to investors. This uncertainty can lead to a loss of expected income for investors.

  4. Write-off Option. Another risk is that AT1 Bonds have a write-off option for the issuing bank. If the bank chooses this option, it can write off all the remaining bonds without seeking the investors’ consent. This could result in a total loss of investment for bondholders.

  5. High-Interest Rates. While the risks associated with AT1 Bonds make them risky, they also come with high-interest rates, making them attractive for investors seeking higher yields. However, the higher returns come at the cost of higher risks.

  6. Unsecured Nature. AT1 Bonds are unsecured, meaning they lack collateral backing. In case of a bank’s financial distress or failure, there is a higher chance that bondholders may face losses compared to holders of secured bonds.

Despite these risks, AT1 Bonds remain popular and are advised by some wealth managers to clients with a higher risk appetite. However, investors should carefully consider their risk tolerance and investment goals before investing in AT1 Bonds, as they may not be suitable for those seeking safer and more stable returns.

Ways to buy AT1 bonds

  1. Primary Market Purchase. Investors can buy individual bonds directly from the issuing company in the primary market.

  2. Secondary Market Purchase. Alternatively, they can purchase bonds from the secondary market, buying from individuals who already own the bonds and are willing to sell them.

  3. Bond Exchange-Traded Funds (ETFs). Investors can invest in bond ETFs, which offer a diversified portfolio of bonds.

  4. Bond Mutual Funds. Another option is to opt for bond mutual funds, providing diversification through professionally managed portfolios.

  5. Fund Manager Services. Investors can also utilize the expertise of a fund manager who handles the purchase and sale of securities on their behalf in exchange for a fee.

  6. Broker Purchase. Bonds can be purchased from brokers, providing access to a variety of bond offerings.

  7. Online Brokerage Sites. Many online brokerage sites offer the convenience of buying bonds online.

Examples

During an economic crisis, Keepsafe Family Bank experienced a decline in its capital ratio, falling below 5%. Due to its worsening financial condition, the bank decided to write off its AT1 bonds, totaling $15 billion. Unfortunately, these unsecured bonds posed a significant risk to the investors’ portfolios, resulting in losses for them.

In response to the unfavorable outcome, the investors, including some from Swiss private banks, initiated protests and even contemplated legal intervention. However, since the AT1 bonds were specifically designed to absorb losses, the investors’ efforts to challenge the write-off proved ineffective. Consequently, the bonds were written off following the terms outlined in their policies and the Basel II norms governing such financial instruments.

This scenario evoked memories of past economic crises where precarious banks’ collapses had arranged a domino effect, leaving investors scrambling to recover their money. In some instances, government bail-outs had to step in to stabilize the financial system.

The write-down of AT1 bonds caused particular pain for certain investors, including Union Bancaire Privée, a great rival of the Swiss bank in question. However, given the first-instance nature of this situation, regulators and market participants carefully observed the developments and its potential implications on the broader financial sector.

Despite the losses investors face, AT1 bonds remain a relevant and widely used contingent convertible instrument for banks in absorbing losses during turbulent times, enhancing financial stability, and maintaining their capital adequacy.

Additional Tier 1 Bonds vs. Tier 2 Bonds

AT1 bonds are perpetual, they hold a subordinate position to Tier 2 bonds within the bank’s capital structure. These bonds serve as banksprimary source of funds, encompassing both shareholders’ capital and retained earnings.

However, Tier 2 bonds occupy a lower level of seniority, being subordinate to unsecured creditors, bank depositors, and senior bonds. Unlike AT1 bonds, Tier 2 bonds come with a minimum maturity period of 5 years. Although they also aim to absorb losses, their inclusion requirements are less stringent than AT1 bonds.

Tier 2 bonds fulfill various roles, including serving as subordinated term debt, hybrid capital instruments, undisclosed reserves, general loan loss reserves, and revaluation reserves within the bank’s capital composition.

The issuance of both AT1 and Tier 2 bonds is part of the banks’ overall capital-raising strategies. Banks issue these bonds to raise capital from investors, who invest their money in return for periodic interest payments and the potential for capital appreciation.

FAQ

  • What is the size of the AT1 market?

  • Is investing in AT1 Bonds safe?

  • Why do investors like AT1 bonds?

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