The solid balance sheets and high profitability of banks provide a strong foundation for deeply subordinated bank bonds. They offer high returns at low risk.
So-called AT1 bonds, or cocos, are an attractive outlier in the financial markets. The relatively high effective yield in particular captures investors’ imagination, said senior investment strategist Erik Schmahl of Rabobank in a conversation with Investment Officer. “While the yield on European corporate bonds is now below 3 percent, it’s over 5 percent for cocos. And these are liquid bonds with short duration and good credit quality.”
Yet investors remain skeptical, according to Schmahl, mainly because cocos are not included in bond indices and are sometimes dismissed as equity. “That’s nonsense,” he said, “because cocos are very comparable to regular subordinated bank bonds, which also take a hit when a bail-in occurs or when a regulator forces the bank to write down its capital.”
Trust
Confidence in cocos took a major blow during the Credit Suisse crisis in 2023, when it became clear that the takeover by UBS meant that some 16 billion Swiss francs in AT1 debt would be written down to zero at the order of the regulator. AT1 holders, including Rabobank, had to fully write off their investments.
Schmahl: “I didn’t have much of a problem with the fact that we were affected at the time, because that’s part of the risk. But there was justified anger among AT1 investors because shareholders still received something. It would have been much better if we had also received Credit Suisse shares.”
Recovery came when the British regulator and the European Central Bank stated that the Swiss regulator’s actions surrounding Credit Suisse should not be repeated. “That saved the asset class,” said Schmahl. “Risk premiums have now also returned to the levels seen before the Credit Suisse collapse.”
Few buyers
Technically, the strategist still finds it a strange market. “Cocos are absent from benchmarks because institutional investors don’t always want to invest in deeply subordinated bonds. Banks, however, are required to issue them and pay handsomely to do so. They must show regulators that they can raise this type of buffer capital from investors. There are therefore few natural buyers for cocos. For us, that makes it an attractive asset class with high returns.”
Marc Stacey, bond specialist at RBC BlueBay, added that the absence of cocos from bond indices means they are an active investment for most bond investors. “That partly explains the discount at which cocos trade.”
Cheap and safe
Over the past 12 months, cocos have returned more than 10 percent. European bank stocks have done even better, with a return of more than 60 percent. “Banks have lagged behind in the markets for years but are now performing well thanks to improved profits and balance sheets,” said Schmahl. “The very strong buffers make the likelihood of banks having to write down cocos or suspend interest payments particularly small.”
Stacey also pointed to the solid balance sheets and profitability of banks, which in his view “provide a strong foundation for the investment case in bank bonds.” “In fact, cocos have never been as safe as they are now.”
One major reason for the increased profitability of European banks, according to the RBC BlueBay specialist, lies in higher interest rates. “Their operating profits have risen by roughly 70 percent since 2020. Net interest income accounts for around 60 percent of profits and remains high enough with the current policy rate of 2 percent in the eurozone.”
That, combined with “strong capital and liquidity ratios,” makes cocos, according to Stacey, “plainly cheap.”
Although risk premiums have narrowed, Schmahl still finds them attractive. “Currently, the spreads on cocos are 2.3 times those of normal subordinated bank bonds, and that’s still substantial given the moderate risks. We therefore expect this ratio to move to 2 or lower. Higher spreads are achievable in high yield and EMD, but then you take on more credit or political risk. In our view, the risks of cocos are easy to explain, and this instrument fits perfectly in bond portfolios.”
Risks
According to Schmahl, AT1s have not suffered from rising long-term interest rates. Although perpetual, they can be redeemed after five years. “Most banks do that as well. If no early redemption takes place, the coupon is reset based on the five-year swap rate plus a spread. In that sense, the risks are limited.”
Stacey added: “The CET1 capital ratio of European banks averages around 16 percent, providing bondholders with a huge buffer against potential losses. Shareholders, after all, take the first hit. Moreover, European banks are expected to generate about 400 billion euro in profits next year, excluding provisions, whereas they were barely profitable before due to ultra-low or negative rates.”
He believes the risk-return profile of cocos stands out positively in the current environment. “Risk assets are almost perfectly priced, and corporate bond spreads are low. In this context, AT1 bonds offer a high yet safe effective yield,” said Stacey.
That’s why the BlueBay Financial Capital Bond Fund invests mainly in cocos, alongside other bank bonds. The fund focuses on investment-grade “national champions.” Stacey: “Like ING, ABN Amro, and Rabobank in the Netherlands, which are crucial for the economy and the financial system.”