Can the stop of dividend extend to coupons on AT1s? what are the valuation on the asset class? How is the outlook for At1/Coco and subordinated financial bonds in general?
Impact for the fund: Limited thanks to our strong issuer selection and exposure to the best issuers
First of all, these are proposals from the European Parliament to amend CRR (Capital Regulatory Requirement), and as such it needs to be formalized and agreed with the European Council and Commission before being voted until mid-June. Furthermore, it is highly likely that as part of the discussions and review the advice of the ECB will be taken into account. So from a process perspective, this should be seen as an early draft that will evolve until agreed upon and voted.
Secondly, on the potential suspension of AT1 coupons and dividends until October 2021. While on dividends this is a possibility, we view a “hard” date as less likely, as regulators and supervisors already have the ability to force banks to shut dividends off (as is currently the case) and payments of dividends will in any case depend on (1) visibility on the Covid-19 impact on the economy and (2) banks’ capital buffers and own fundamentals. Moreover, dividends being shut off is an equity story and not a credit story. For AT1 CoCo coupons, we view this as extremely unlikely given:
- Banks have been very recently allowed to use more AT1 and Tier 2 to fill capital requirements, if AT1 coupons are shut off, issuers will not be able to issue.
- Shutting off AT1 CoCo coupons has a very marginal impact on banks’ capital positions compared to dividends
- The ECB has been very vocal that there is no willingness to shut off AT1 coupons, unless there is a breach of MDA
So all-in-all, we see the risk of a ban of AT1 coupons until Oct-21 as very unlikely as (1) the CRR amendment text will evolve before being voted and (2) shutting off AT1 coupons would be counterproductive and contrary to the regulators/supervisors’ view.
For the moment there has been very limited impact on AT1 CoCo valuations, and actually the market has been fairly strong in the first three days of June, with the EUR AT1 CoCo index up 2%. Our view remains that coupons risk is bank-specific (upon breach of capital requirements), and therefore being involved in the strongest names is the best way to mitigate this risk.
We continue to see strong upside in the sector given very attractive valuations and very strong fundamentals of the banking sector. Q1 2020 results has shown the resilience of the sector and capacity to absorb higher credit losses as well as to support the real economy during this time of uncertainty. Spreads are currently around 600bps on EUR AT1 CoCos, and as a large portion of the market remains priced to maturity (extension risk priced in) there is strong upside on a re-pricing to call.
We have started to see issuance normalize and more subordinated debt deals have come through in the past weeks, mainly Tier 2 of high quality banks. There has only been one AT1 CoCo deal, which reflects very wide spreads in the market. We expect to see more issuance over the coming weeks and months, depending on market conditions, as banks are now allowed to fill a larger portion of their capital requirements with Tier 2 and AT1 CoCos.