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Executive Summary

  • Extension risk was one of the key themes in subordinated financial debt markets for 2018, particularly in Additional Tier 1 (AT1) contingent convertible bonds (CoCos)
  • Instruments re-pricing to perpetuity has exacerbated weak performance due to a general risk-off tone in markets
  • With all eyes on AT1 CoCos, little attention has been paid to legacy bank capital and the insurance subordinated market
  • Looking beyond AT1 CoCos, we maintain our view that extension risk is limited and see value in investing across the capital structure to mitigate risk

Extension risk – the basics

Looking at the structure of AT1 CoCos is a useful exercise in understanding the mechanics of extension risk. Extension risk refers to the fact that an AT1 is either called at par, after the requisite number of years, or the coupon is reset for a further period if not called. The risk is that as spreads widen demand from investors lessens, as they buy on the expectation the bond will be called at a specific date, and can therefore impact market pricing. To illustrate, let’s assume a bank issues a perpetual bond in USD today with an initial five-year non-call period and an 8% coupon. If the five-year swap rate in USD is 3%, this is equivalent to an initial spread of 5% (or 500 bps). After five years, if the bank decides not to call the bond, the new coupon will be the five-year swap rate at that time plus the initial 500 bps spread (“reset spread” or “back-end”).
It is important to consider what is likely to happen in five years. The actual decisions on whether to call or not are based on a wide range of factors and can be specific to each situation, but let us think about the cost of refinancing to the issuer.
The issuer needs to consider the spread (cost for the issuer) of a potential new AT1 and compare this cost to the reset spread of the existing instrument. If the spread of a potential new AT1 is below the reset spread, the issuer will be incentivised to call (as the new instrument has a lower cost), while if the spread is above the issuer will likely leave the bond outstanding. Therefore,
the reset spread is a key driver of extension risk.
For investors, the risk is linked to both unforeseen non-call events (not reflected in the price) and reassessing the risk of non-calls where prices drop as a result. To illustrate an extreme example of the former, Chart 1 shows the sharp 14% fall on the day Standard Chartered announced the non-call of a legacy Tier 1 instrument in late 2016, reflecting the market’s adjustment for a new coupon set at 151 bps over three-month Libor (the all-in coupon was circa 2.55% after the non-call
compared to the previous level of 6.409%). Clearly investors had not anticipated this non-call event and the adjusted price reflected both a longer maturity (uncertainty of future calls) and the lower coupon.
Past performance is no indicator of current or future trends. References to a security are for illustrative
purposes only and are not recommendations to buy or sell that security.

We believe the performance of AT1 CoCos in 2018 is a good example of the reassessment of non-call risks. As global AT1 CoCo spreads widened, by circa 160 bps, over the year1 there was a negative feedback loop (wider spreads led to increased pricing to perpetuity, which in turn pushed spreads wider) and this disproportionally impacted bonds with lower reset spreads.

Chart 2 illustrates where the lower reset BBVA bond widened more than the higher reset equivalent bond. As the spread rose above the reset spread, the market started to price in a significant risk of non-call, prompting the pricing to perpetuity to accelerate.

All eyes on AT1 CoCos in 2018

AT1 CoCos are perpetual, with no final maturity, and can theoretically never be redeemed (we discuss later why this is
unlikely). The instruments carry no incentive to call and, as these are fully eligible as capital under the current regulatory framework, are an efficient source of capital compared to shareholders’ equity (estimated cost of equity circa 10-12%
compared to an average 6.2% Yield on AT1 CoCos). We expect the main driver of decisions to call to be refinancing
economics – where issuers would call if they can issue a new AT1 at a cheaper level.
When spreads on AT1s significantly widened in 2018, a move that was exacerbated by increased pricing of instruments to perpetuity, there was a mechanical effect that decreased the likelihood of calls due to higher potential refinancing costs, which in turn raised fears of bonds being extended past their next call date. As investors require higher yields and spreads as compensation for a potentially longer holding period (ie extension past the next call) and a lower coupon (than on an equivalent AT1 issued) this caused further weakness in the market. And this weakness was compounded by the fact that circa USD 20 billion of had been AT1s from late 2017 to early 2018 (Q317-Q118) at the peak of the market with record low reset spreads.
Chart 3 illustrates the scale of this change: close to 70% of the AT1 CoCo market was pricing a non-call at the end of December 2018 compared to just 2% at the end of January 2018, suggesting the market expects more than half of instruments to be extended beyond the first call date.

Heading into 2019, we believe extension risk will likely remain in focus as there is a wave of instruments up for call currently

priced to non-call. This marks a structural shift compared to 2018 where the AT1s up for call were generally refinanced at cheaper levels for issuers and had high back-ends. Despite the potentially negative initial impact on prices, should one or several instruments not be called, the market has in our view priced-in extension risk to a large degree. However, instruments with lower reset spreads are now almost fully priced to perpetuity, which we think is wrong.
There are several reasons why we think that true perpetuity is unlikely. First, re-pricing of instruments to perpetuity has been driven by a widening of spreads of AT1 CoCos, with the reasoning that an issuer would not be able to refinance the instrument at cheaper levels. While this holds true for an instrument callable in the near future (issuers need to gain
regulatory approval to call bonds and hence refinance several months ahead of the call date), for other instruments callable in the more distant future the decision to call will likely be based on the spreads at that point in time. In this instance, less extension risk should be priced-in based on current spreads. For the former (ie bonds callable in the near future), these will remain callable periodically and hence will likely be called at a later call date if spreads move tighter and the issuer can refinance at more attractive levels.
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