Reiterating the value in AT1s
Saving up for a rainy day. The European Central Bank (ECB), along with other regulators, recently recommended for banks not to pay dividends or engage in share buybacks during the COVID-19 pandemic (concerning dividends at least until 1 October 2020). Outside of Europe, American banks have also stopped their buyback programmes (rather than dividends, which are much smaller at US banks).
This is in the interest of capital preservation in the midst of an ongoing viral outbreak that would likely see asset quality deterioration down the road. The move stoked fears among investors concerning the uncertain magnitude of risks in the banking sector, no doubt unearthing some repressed memories from the Global Financial Crisis (GFC) in 2008.
Can lightning strike the same place twice? While it is difficult to ascertain clearly the extent of damage of a prolonged economic slowdown on bank asset quality, one thing is clear – the banking system is not facing the same level of insolvency risks as it did during the GFC.
The improvement in regulatory safeguards since the GFC has served to strengthen the balance sheet and liquidity positions of banks around the world, especially those that are deemed global or domestic systemically important.
Taking a broader look across Tier 1 ratios across these larger banks, we observe that capital positions have improved between 1-14% since 2007-08, undergirding the banks’ abilities to better withstand such potential shocks (Figure 1). Moreover, with nimbler policy support from central banks and the withholding of dividends, capital buffers are now unlikely to be hastily eroded (dividend cancellations are projected to increase bank capital by around 50-75 bps in CET1 terms on average).
Figure 1: Bank Tier 1 capital ratios have improved significantly since the 2008 crisis
Source: Bloomberg, DBS
Would AT1 coupons be the next shoe to drop? The rational concern would be that if banks are cancelling dividends to preserve capital, AT1 coupons would inevitably follow suit. However, there are several valid arguments for why this may not be the case:
1) The marginal benefit is low – AT1 coupon savings for a bank in terms of capital is relatively modest relative to equity dividends (roughly about one eighth the size);
2) The marginal cost is high – coupon skips could re-price the bank’s costs of other debt instruments higher, which defeats the purpose of saving on AT1 distributions in the first place;
3) With equity investors on the side lines and net interest margins (NIMs) on the downtrend, stopping AT1 coupons may freeze up one of the banks’ last avenues of replenishing capital; and
4) The regulators understand that investors in bank equity and bank AT1 notes are different.
Ultimately, we do expect that structural subordination stands holders of AT1 securities in better stead. Where concerns were once raised that AT1 securities technically ranked below equity in the capital structure given that the loss-absorption mechanism could occur before the impairment of equity, we see now that equity holders still took the first hit (in terms of dividend cancellation) in the name of capital preservation.
Fewer avenues to extract yield from banks. Bank depositors were the first to see returns vanish under the environment of low yields, but it is ironic that bank equity holders are now not faring much better despite having to go down the risk spectrum. The answer, as always, seems to lie somewhere in the middle – in the case with AT1s, the spread differential of global AT1s average yield-to-call (YTC) above global bank equity dividends is still fluctuating around 340 bps (Figure 2). This is all the more attractive if you consider that more banks around the world may heed the call to shore up capital by freezing dividend payments going forward.
Figure 2: Global AT1s yield-to-call in excess over global banks’ dividend yields
Larger banks with superior capital buffers would better weather the storm. AT1 investments are not devoid of risks; the longer the persistence of economic weakness, the higher the likelihood that even AT1 distributions would face risks of stoppage. Concerns mainly centre around the weaker banks (specifically in Italy, Spain, Portugal, and Germany) which will need evaluation on a case-by-case basis.
The best risk-reward balance lies with the larger Investment Grade banks in each region that have superior capital buffers – currently yielding between 9-11% YTC. If investors are able to take some price volatility, these names are likely to overturn their recent underperformance at the first sign of a global recovery.
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