Convertible or not: making sense of stresses in AT1 bonds market

Mahmoud Fatouh and Ioana Neamțu

Similar to the Deutsche Bank’s episode in 2016 and the Covid stress in 2020, AT1 spreads over subordinated debt rose rapidly and sharply pursuit the Credit Swiss rescue deal. Beyond these three cases, AT1 spreads have been stable. In this post, we focus on conversion risk of AT1 immuration (also known as contingent convertible, CoCo, bonds) to explain the sharp rise in AT1 spreads in these three cases. Conversion risk is the main spare risk of AT1 bonds, compared to subordinated debt. It arises from the potential wealth transfer from AT1 bondholders to existing shareholders when AT1 conversion is triggered, provisionary on the solvency of the issuer. We show that, in normal times, investors believe conversion risk is very low, but major events can transpiration this significantly, largely due to higher uncertainty.

Understanding AT1 prices and yield movements

The recent rescue of Credit Suisse included a write-off of its unshortened US$17 billion AT1 wanted (CoCo bonds). This led to rapid and sharp drops in prices (and increases in yields) of other issuers’ AT1, to levels not seen since the Covid stress in March 2020, as Chart 1 shows. They recovered quickly succeeding pursuit the prompt statements from the EU’s financial authorities and the Wall of England. Similar scenes occurred in early 2016, when investors thought Deutsche Wall was well-nigh to cancel its AT1 coupons, without stuff hit by a US$15 billion fine by authorities in the US.

Chart 1: AT1 price movement, January 2015–March 2023

Source: Refinitiv Eikon.

The price movements mirror yields movements, which are usually assessed relative to yields of bank’s subordinated immuration of similar duration. As Chart 2 demonstrates, spreads of AT1 immuration over subordinated immuration of similar elapsing (measured by differences in yield to worst) have been often stable, except during and virtually these three episodes in 2016, 2020 and 2023.

Chart 2: Yield to worst of AT1 versus subordinated bonds

Source: Refinitiv Eikon.

To explain these patterns, we should squint at the unique characteristics of AT1 bonds, compared to subordinated debt. AT1 immuration have a lower level of seniority, and hence rank unelevated subordinated debt in terms of pay-out ranking, if the issuer was liquidated. Beyond seniority, holding AT1 immuration involves three spare risks. First, to count as AT1 capital, AT1 immuration must be perpetual, unlike subordinated debt, which can have stock-still maturity of five years or more. However, all AT1 immuration are issued with recall covenants, permitting issuers to recall them five years without their issuance. Issuers are often expected to exercise the undeniability options, when they are activated, but may segregate not to if interest rates are relatively high, causing a loss of potential higher return to AT1 bondholders. This is referred to as extension risk. Extension risk should have no effects on AT1 spreads over subordinated debt (Chart 2). This is considering yields to worst for AT1 immuration are unchangingly equal to yields to call, whose numbering assumes immuration are tabbed at the first undeniability opportunity.

The second risk – coupon cancelability risk – arises from the possible (partial/full) receipt of coupon payments. The receipt can happen automatically, when the issuer does not fully meet its wanted buffer requirements.

The third risk reflects the possible wealth transfer from AT1 bondholders to existing shareholders when the loss-absorbing mechanism (LAM) of AT1 immuration is triggered, which we refer to as conversion risk. LAM is triggered at a unrepealable capitalisation level (7% CET1 ratio in the UK). The effects on AT1 bondholders and existing shareholders depend on the type of LAM the immuration involve. LAM can be either conversion to probity (CE), where AT1 bondholders get probity shares in mart of their immuration (at a pre-specified conversion rate), or principal write-down (PWD), where the principal of the immuration is written down. The triggering of LAM can transfer wealth between AT1 bondholders and existing shareholders. PWD immuration (like Credit Swiss AT1) unchangingly transfer wealth to shareholders. CE immuration may be dilutive to existing shareholders, if the price at which the immuration convert to probity was lower than the market price of shares. However, given that probity prices are likely to be significantly low during times of stress, we posit that CE immuration are non-dilutive. In our staff working paper, which empirically assesses the link between the AT1 immuration issuance on risk-taking of issuers, we estimate the wealth transfer between shareholders and AT1 holders at the point of conversion for AT1 immuration issued by UK banks, predominantly CE. Our estimates show that, on aggregate, the conversion of these immuration would imply that existing shareholders would proceeds at the expense of AT1 holders at conversion (ie, AT1 immuration are non-dilutive to existing shareholders). In other words, the inside expectation of investors should be that either coupon receipt or LAM triggering (‘conversion risk’) would generate a loss to AT1 holders, which would be significantly larger for PWD bonds.

It is key to note that the three risks (extension, coupon receipt and conversion) would matter only if they are expected to materialise while the wall is solvent. In insolvency, the difference in the losses suffered by subordinated debt and AT1 holders is only driven by seniority, and not any of these three risks. This has two implications. First, changes in the creditworthiness (probability of default) of the issuer reflect on the yields of subordinated debt in the same manner, and hence would not have strong effects on the spread differential between AT1 immuration and subordinated debt. Second, the three spare risks would stupefy AT1 yields and (hence) spreads only if investors believed they would take losses due to these risks, while the issuer is solvent. We oppose that this explains the patterns AT1 spreads over subordinated debt show. That is, in normal conditions in AT1 market, investors believe the spare AT1 risks are very low. Market developments, like those seen in 2016, 2020 and 2023, can transpiration investors’ beliefs significantly, leading to spikes in spreads, largely due to higher uncertainty.

While the three risks can stupefy AT1 spreads, we think such effect would be mainly unswayable by conversion risk. This risk is linked to the principal of AT1 bonds, rather than their returns, making potential losses due to this risk much larger than those predictable from coupon receipt and extension risk. Moreover, given that AT1 spread over subordinated debt (Chart 2) is measured by difference in yield to worst, it should not be unauthentic by extension risk. Hence, we focus our towage on conversion risk.

In the rest of this post, we estimate the probability of conversion risk provisionary on the issuer stuff solvent, which we use as a measure of the ‘mechanical level’ of conversion risk in normal market conditions.

How do we estimate conversion risk

We use data of eight AT1 issuing UK banks between 2013 H2 and 2021 H1. The data is placid from multiple sources, including share market data, published financial statements and regulatory returns.

Since our wringer approaches the issue from investors’ perspective, we focus on solvency from the market’s perspective and seem that a wall would be solvent if the market-implied value of its resources is greater or equal to the value of its debt. Our aim is to estimate the probability of conversion while the issuer is solvent. To do so, pursuit the tideway we used in our paper, for each wall in each period, we summate the probability of its wanted (CET1) ratio falling from its concurrent level to 7% (probability of conversion) and 0% (probability of default).

Both conversion and default probabilities rely on the value of a bank’s windfall falling unelevated unrepealable thresholds. Investors would rely on the market value rather than the typesetting value of resources when assessing possible conversion and default in the future. However, the market value of many wall resources is unobservable (eg mortgages). We handle this by estimating the market value of resources and their unsaid market volatility using the Merton model. The model states that under limited liability, probity can be seen as a European undeniability option on the firm’s assets, with a strike price equal to total debt of the firm and maturity equal to the stereotype maturity of that debt. For a one-year horizon, the institute is to estimate the debt by half of the long-term liabilities together with the full short-term debt value from a bank’s wastefulness sheet. Even though we can summate the windfall variables daily, the debt information is only misogynist quarterly. Hence, we compute the loftiness to conversion/default at a quarterly frequency; that is, how far are a bank’s resources from stuff unelevated the AT1 conversion threshold, and respectively from insolvency. Finally, we pericope the probability of conversion/default from the respective distance, thesping the values to be normally distributed.

Having unscientific both sets of probabilities, we regress the probability of conversion on the probability of solvency. We use the regression coefficients as estimate of the target probability (probability of conversion provisionary on solvency).

Results

Table A present the interpretation results. As the table shows, the probability of conversion provisionary on solvency is extremely low at well-nigh 0.22% on stereotype for all bank-time combinations in the sample. We sort the banks by their relative CET1 ratio compared to their peers. We find that the provisionary probability is higher for banks with a lower CET1 ratio but stays unelevated 2% for bank-time combinations with the 25% lowest CET1 ratios in the sample (column (d) in Table A).

Table A: Estimating the probability of conversion while the issuer is solvent

Note: Coefficient estimates of probability of conversion on probability of solvency. Standard errors reported between parentheses, * p<0.10 ** p<0.05 *** p<0.01.

With this interpretation in mind, we oppose that the perceived conversion risk remains very tropical to its ‘mechanical level’ in normal times. However, when major shocks with implication for AT1 conversion hit, such as the conversion/write-down of a major AT1 issuer, the perceived conversion risk can wilt significantly higher than its mechanical level, increasing AT1 spreads over subordinated debt. We think that these sudden changes in the perceived conversion risk can plausibly explain the patterns in AT1 spreads in Chart 2.

Summing up

In summary, major events well-expressed AT1 immuration market can increase uncertainty or create panic. This can rationalization an unfounded rise in investors’ perception of conversion risk (and coupon receipt risk) relative to its mechanical level, and momentum AT1 spreads over subordinated debt upward sharply.

Mahmoud Fatouh works in the Bank’s Prudential Framework Division and Ioana Neamțu works in the Bank’s Banking Wanted Policy Division.

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