Risky Bank Bonds Prove Stable Amid Market Turmoil

(Bloomberg) — The latest convulsions in bond markets exposed a quirk: Some of the riskiest, most complex structures have ended up being among the most stable.

Additional Tier 1 bonds — deeply subordinated debt banks issue for regulatory purposes — have been 75% less volatile than high-grade corporate bonds, according to rolling 10-day data, compiled by Bloomberg. Mainstream bonds, particularly long-dated government issues, are being hit by concerns over everything from inflation to fiscal woes to a flood of corporate supply.

Their relative tranquility underscores a hunt for yield in an asset class that captured headlines when Credit Suisse zeroed $17 billion worth of AT1s in 2023. Back then, AT1s were 10 times more volatile than high-grade bonds, and almost twice as volatile on a 10-day rolling basis during the height of the Iran War earlier this year.

“There’s very little sensitivity to rates, little sensitivity to what’s going on in the background in terms of macro,” said Romain Miginiac, fund manager and head of research at Atlanticomnium SA. He quipped that they are now a risk-free asset, which as a comment “is a bit more provocative than anything else, but it’s true that if you look at it, how it’s behaved over the past 12 months, it is as stable as it gets.”

On Thursday, just as US government bonds unwound all the gains from Treasury Secretary Scott Bessent’s bold intervention to stem a rise in yields, prices of AT1s globally were down less than two hundredths of a cent.

There’s good reason for that. Just earning the coupon income is enough to satisfy total return targets for about 80% of investors in a survey published this week by ABN Amro Bank NV. Investors whose requirements are lower than what they can earn in AT1s “will maintain high bids,” said Shanawaz Bhimji, head of credit strategy at the Dutch bank.

Investors have been flocking to AT1s, which are also known as contingent convertible bonds, thanks to elevated yields in debt sold by some of the biggest banks in the world and the rising government bond rates are only making them more lucrative.

The number of fixed-maturity funds — vehicles aimed at mom-and-pop investors with a specific end date — investing in those perpetual AT1s has almost doubled since November, based on data compiled by Bloomberg. Unconstrained funds, which can bet on any corner of the fixed-income world, also are buying AT1s as managers seek higher returns at a time of lofty credit market valuations.

AT1s are what are known as “high beta” securities, meaning their prices typically rise more than the broader bond market in rallies and fall more sharply during selloffs because of their higher risk and loss-absorbing features. Their resilience during recent swings in benchmark debt is therefore, in theory, unusual.

High yields explain some of the paradox, helping to underpin steady demand. AT1s offer beefier yields to compensate investors for a number of additional risks over vanilla bonds, such as the potential for skipped coupons, uncertain repayment and the possibility of being the first among bondholders to lose money if a bank goes under.

The average yield on Bloomberg’s global contingent convertible bond index stands at 5.7%, compared to under 5% for investment-grade corporate bonds and about 3.7% for an index of government debt.

‘Very Complacent’

Still, this constant bid for yield has allowed risk to build up into the system. AT1 spreads, a key metric that can determine whether issuers will repay the bonds at the first opportunity, have collapsed to record-tight levels. The global CoCo index’s spreads dipped below 200 basis points for the first time last week.

Investors willing to ignore razor-thin spreads to chase yields are “very complacent,” Miginiac said.

BNP Paribas SA recently sold a dollar-denominated AT1 with its tightest-ever so-called reset spread in the currency. This followed a series of US lenders, including Goldman Sachs Group Inc. and Bank of New York Mellon Corp., which set this summer their own post-crisis tights in their preferred shares, the local instrument to raise AT1 capital.

“Demand for the AT1 asset class remains very strong,” said Luca Evangelisti, an investment manager at Jupiter Asset Management. Buying by investors who are new to the asset class as well as veteran CoCo holders is likely to provide support for further issuance, he said, “with order books potentially remaining multiple times oversubscribed, as we have seen year to date.”

Evangelisti said he’s “increasingly selective” due to tight reset spreads and limited concessions in new deals.

And Man Group recently warned that AT1 investors are piling into the sector “without pausing to weigh what they are taking on.”

Still, the balance sheets of European lenders, the main source of AT1 bond supply, have improved to the point where investors have few concerns about the strength of the sector. Their stock prices have even outperformed the technology sector’s so-called Magnificent 7 this year. This could help soften the blow of future bouts of market stress.

“Historical correlations between AT1s and broader risk-off moves, whether in equities or government bonds, may not always be a reliable guide to future performance, particularly when the catalyst has no direct implications for the banking sector,” said Jupiter’s Evangelisti.