Seven Pillars of Wisdom on the AT1 Market

The Federated Hermes Credit Team shares seven pillars of wisdom on the AT1 market

1. The European Banking Authority is this month holding talks on ways to boost investor interest in the AT1 Market following the collapse of Credit Suisse, which resulted in Swiss Authorities wiping out $17 billion in AT1 Bonds.
2. With this in mind, Federated Hermes has outlined seven key reasons why it is essential to restore trust and investor engagement in the asset class.

 Filippo Alloatti, Head of Financials (Credit) at Federated Hermes Limited:

AT1s should trade inside the generic 10% cost of equity for the listed European (& UK) banks. More broadly, the asset class serves an important role for the following key reasons:

1. Size: The AT1 market is important for banks’ capital, with over $245bn outstanding. A functioning AT1 market therefore plays a significant role in the pricing of (much larger) other bank liabilities, such as senior bonds.
2. Unintended consequences: Without AT1s, banks would have to hold more common equity (CET1), restricting their lending capacity, which would be particularly detrimental for bank-centric Europe, and lowering their prospective Return on Equity (ROE).
3. Regulatory support: Regulators have stood behind the asset class in difficult periods before (i.e., oil price slump of Jan ’15, Covid in Mar ’20, 1Q23 after the Credit Suisse event). If the regulators want this asset class to be revived following the collapse, then it needs more security and fixed income-like attributes.
4. Rates: We are at, or not far from, peak rates. This should support depressed cash prices.
5. Supply: Supply has been non-existent since the Credit Suisse demise. Banks are running excess CET1 ratios and most of the ’23 calls have been pre-financed.
6. Fundamentals: Strong 1Q report card; benefits of normalised rates (higher NII), high capital, stable funding, and stable asset quality outlook. With markedly enhanced disclosures (deposits, CRE, etc).
7. Pricing: Only about 10% of the market is trading to first call. Looking at history, this is too harsh, for the market will eventually differentiate between issuers.

Also read: Is a US Default a Real Possibility?

Mohammed Elmi, Senior EMD Portfolio Manager at Federated Hermes:

If Erdogan, as is now likely, wins the second round runoff against Kemal Kilicdaroglu later this month, he will have a simple choice to make: economic orthodoxy or the status quo.

His room for manoeuvre has narrowed somewhat with a record current account deficit of 5.7% of GDP on a rolling 12 month basis, and a deteriorating fiscal position. Turkey usually relies on external financing to plug its gross external financing requirements, but the market will be wary and with core rates at these elevated levels, new funding will be tough to secure. Although we expect the lira to continue to weaken and the pressure to build in the near term, Erdogan is a pragmatist and the market may well eventually force his hand.

I expect foreign investors will be extremely wary, and will be closely watching Erdogan’s appointees to the key economy and finance briefs. If we see some market friendly appointments, this could be a sign that policy could be evolving in the right direction and on that basis bonds could pare some of the losses incurred over the past 24 hours. 

Geir Lode, Head of Global Equities at Federated Hermes Limited:

Equity markets were calm this week as investors awaited news of a deal on the US debt ceiling. President Biden’s indication on Wednesday that he wouldn’t allow the US to default prompted US markets to rise, with Europe following suit on Thursday morning. Growing optimism about the deal has provided some relief across most sectors, especially in regional banks which have had a torrid few months. While clearly a debt-deal would be a positive, measures of investor sentiment suggest a deeper malaise, and removing this one – admittedly large – risk may not be enough to reawaken the bulls.

Although debt ceiling talks have dominated the news cycle, the issue of persistent inflation still lurks in the background. There seems to be more talk of a “soft landing” for the economy, but we think this could be overly optimistic. Rates have likely peaked and will eventually come down, but there is a very real risk that credit spreads will continue to widen as recession risk persists. We continue to closely monitor the persistence of inflation and the tightness of the labour market.

Companies with over-leveraged balance sheets are sensitive to uncertain credit conditions and commentary over the past earnings season has highlighted the continuing impact of cost pressures on profit margins. As interest rate expectations fall we favour growth stocks with strong, sustainable profit margins: we will look for opportunities in mega-cap technology names with their protective moats, healthy balance sheets and an ability to appeal to both growth-focused and nervous investors.