Additional Tier 1 Capital: High Yield in a Highly-Regulated Sector

European bank Additional Tier 1 (AT1) securities are often associated with a single event: the CHF16 billion write-down of Credit Suisse AT1 bonds in 2023. As the largest AT1 loss on record, it fundamentally altered perceptions of the asset class. Less widely recognised is that, since AT1 instruments were introduced under the post-global financial crisis regulatory framework in 2009, there have been only two AT1 write-down events. When a bank fails, AT1 investors are expected to absorb losses - that is precisely how the instrument was designed.

Why have bank failures been so rare? The answer lies in the regulatory architecture established after the global financial crisis. Over the past 17 years, European banks have been required to substantially increase capital, strengthen liquidity, tighten underwriting standards and undergo regular supervisory stress testing. The result is a banking sector that is significantly better capitalised and more resilient than before the financial crisis.

This evolution has also changed the practical significance of AT1 trigger levels. AT1 securities - also known as contingent convertible bonds, or CoCos - typically convert into equity or are written down when a bank's Common Equity Tier 1 (CET1) ratio falls below 5.125%. That threshold was established in 2009. Today, every European bank must operate above regulatory capital requirements already far in excess of this historic level, meaning that, in practice, there would be a supervisory intervention long before a contractual AT1 trigger became relevant. Against this backdrop, nearly half of the European AT1 market is now rated investment grade, despite offering yields that continue to exceed those available in the broader high-yield corporate bond market.

If credit fundamentals have strengthened so significantly, why do AT1s continue to offer such attractive yields?

Part of the answer is complexity. Banking is one of the world's most heavily regulated industries, and the framework governing AT1 securities has evolved continuously since 2009 through new regulations, supervisory guidance and regulatory clarification. Understanding this framework is not simply advantageous - it is essential to assessing risk accurately, and its complexity continues to deter many investors.

The second factor is market structure. When AT1s were introduced, investors chose not to include them in the major global high-yield bond indices. As a result, many investors own the asset class as an off-benchmark allocation. During periods of market stress, these positions are often among the first to be reduced in a knee-jerk reaction, regardless of issuer fundamentals, causing AT1s to underperform initially. Conversely, once investors recognise that the risk-off event is unrelated to bank fundamentals, AT1s have historically recovered faster than many areas of the corporate credit market. The market behaviour during the COVID-19 sell-off provides a clear example of this dynamic. This combination of structural volatility and technical dislocations continues to deter many investors, despite being a defining characteristic of the asset class rather than a reflection of underlying credit quality.

Today, the global AT1 market exceeds US$250 billion, but successful investment requires considerably more than broad market exposure. The market remains predominantly over the counter, with liquidity varying significantly between issuers and individual securities. Identifying relative value, exploiting periods of market dislocation and anticipating the impact of regulatory developments require specialist expertise in both bank credit and regulation.

Equally important is disciplined security selection. Unlike larger portfolios that may need to hold the market's biggest issuers for capacity reasons, more focused strategies can be selective, avoiding issuers such as HSBC, BNP and Barclays where broader macroeconomic, geopolitical or sector-specific risks are judged to outweigh the available return. In AT1 investing, successful outcomes depend as much on the risks avoided as on the opportunities pursued.

Jackie co-manages Spring's Subordinated Debt Fund, is a member of the ECB's Banking Supervision Market Contact Group and headed up Morgan Stanley's Financials Credit Research team from 2000-2023 .

Contact: jackie(at)springinv.com