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 following the Credit Swiss rescue deal. Beyond these three cases, AT1 spreads have been stable. In this post, we focus on conversion risk of AT1 bonds (also known as contingent convertible, CoCo, bonds) to explain the sharp rise in AT1 spreads in these three cases. Conversion risk is the main additional 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, conditional on the solvency of the issuer. We show that, in normal times, investors believe conversion risk is very low, but major events can change 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 entire US$17 billion AT1 capital (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 afterwards following the prompt statements from the EU’s financial authorities and the Bank of England. Similar scenes occurred in early 2016, when investors thought Deutsche Bank was about to cancel its AT1 coupons, after being 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 bonds of similar duration. As Chart 2 demonstrates, spreads of AT1 bonds over subordinated bonds of similar duration (measured by differences in yield to worst) have been generally stable, except during and around 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 look at the unique characteristics of AT1 bonds, compared to subordinated debt. AT1 bonds have a lower level of seniority, and hence rank below subordinated debt in terms of pay-out ranking, if the issuer was liquidated. Beyond seniority, holding AT1 bonds involves three additional risks. First, to count as AT1 capital, AT1 bonds must be perpetual, unlike subordinated debt, which can have fixed maturity of five years or more. However, all AT1 bonds are issued with recall covenants, allowing issuers to recall them five years after their issuance. Issuers are generally expected to exercise the call options, when they are activated, but may choose 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 because yields to worst for AT1 bonds are always equal to yields to call, whose calculation assumes bonds are called at the first call opportunity.
The second risk – coupon cancelability risk – arises from the possible (partial/full) cancellation of coupon payments. The cancellation can happen automatically, when the issuer does not fully meet its capital buffer requirements.
The third risk reflects the possible wealth transfer from AT1 bondholders to existing shareholders when the loss-absorbing mechanism (LAM) of AT1 bonds is triggered, which we refer to as conversion risk. LAM is triggered at a certain capitalisation level (7% CET1 ratio in the UK). The effects on AT1 bondholders and existing shareholders depend on the type of LAM the bonds involve. LAM can be either conversion to equity (CE), where AT1 bondholders get equity shares in exchange of their bonds (at a pre-specified conversion rate), or principal write-down (PWD), where the principal of the bonds is written down. The triggering of LAM can transfer wealth between AT1 bondholders and existing shareholders. PWD bonds (like Credit Swiss AT1) always transfer wealth to shareholders. CE bonds may be dilutive to existing shareholders, if the price at which the bonds convert to equity was lower than the market price of shares. However, given that equity prices are likely to be significantly low during times of stress, we posit that CE bonds are non-dilutive. In our staff working paper, which empirically assesses the link between the AT1 bonds issuance on risk-taking of issuers, we estimate the wealth transfer between shareholders and AT1 holders at the point of conversion for AT1 bonds issued by UK banks, predominantly CE. Our estimates show that, on aggregate, the conversion of these bonds would imply that existing shareholders would gain at the expense of AT1 holders at conversion (ie, AT1 bonds are non-dilutive to existing shareholders). In other words, the central expectation of investors should be that either coupon cancellation 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 cancellation and conversion) would matter only if they are expected to materialise while the bank 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 bonds and subordinated debt. Second, the three additional risks would affect AT1 yields and (hence) spreads only if investors believed they would take losses due to these risks, while the issuer is solvent. We argue that this explains the patterns AT1 spreads over subordinated debt show. That is, in normal conditions in AT1 market, investors believe the additional AT1 risks are very low. Market developments, like those seen in 2016, 2020 and 2023, can change investors’ beliefs significantly, leading to spikes in spreads, largely due to higher uncertainty.
While the three risks can affect AT1 spreads, we think such effect would be mainly determined 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 anticipated from coupon cancellation 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 affected by extension risk. Hence, we focus our assessment on conversion risk.
In the rest of this post, we estimate the probability of conversion risk conditional on the issuer being 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 collected from multiple sources, including share market data, published financial statements and regulatory returns.
Since our analysis approaches the issue from investors’ perspective, we focus on solvency from the market’s perspective and assume that a bank would be solvent if the market-implied value of its assets 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, following the approach we used in our paper, for each bank in each period, we calculate the probability of its capital (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 asset falling below certain thresholds. Investors would rely on the market value rather than the book value of assets when assessing possible conversion and default in the future. However, the market value of many bank assets is unobservable (eg mortgages). We handle this by estimating the market value of assets and their implied market volatility using the Merton model. The model states that under limited liability, equity can be seen as a European call option on the firm’s assets, with a strike price equal to total debt of the firm and maturity equal to the average maturity of that debt. For a one-year horizon, the convention is to estimate the debt by half of the long-term liabilities together with the full short-term debt amount from a bank’s balance sheet. Even though we can calculate the asset variables daily, the debt information is only available quarterly. Hence, we compute the distance to conversion/default at a quarterly frequency; that is, how far are a bank’s assets from being below the AT1 conversion threshold, and respectively from insolvency. Finally, we extract the probability of conversion/default from the respective distance, assuming the values to be normally distributed.
Having estimated 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 conditional on solvency).
Results
Table A present the estimation results. As the table shows, the probability of conversion conditional on solvency is extremely low at about 0.22% on average 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 conditional probability is higher for banks with a lower CET1 ratio but stays below 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 estimation in mind, we argue that the perceived conversion risk remains very close 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 become 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 affecting AT1 bonds market can increase uncertainty or create panic. This can cause an unfounded rise in investors’ perception of conversion risk (and coupon cancellation risk) relative to its mechanical level, and drive 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 Capital Policy Division.
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