Investors are going loco for CoCos

In a distant and forgotten era, around eight months ago, tremors were rippling through the global banking system. Three mid-sized American lenders collapsed in a week. In Europe the venerable Credit Suisse almost went under, before being bought by its rival, UBS. The scramble to merge them threw a cloud over an entire class of bank debt, $1trn of which has been issued over the past decade.

AT1 bonds were supposed to make banks safer after the financial crisis of 2007-09. In good times, they work like normal bonds. But if the issuing bank’s capital falls far enough, some (dubbed contingent convertible notes, or “CoCos”) convert to equity. Some others are written off. AT1s are usually described as being senior to shares and junior to bonds in a liquidation. But when Credit Suisse fell apart, AT1 bondholders were wiped out before shareholders.

The CoCo crowd howled, even as regulators insisted they were following the bonds’ contracts.  It looked as if the entire asset class might be done for, with investors everywhere poring over fine print to see how they would be treated in a similar scenario. AT1 yields rocketed.

Yet today the market for AT1s is not just alive, but thriving. By November 20th the month was already the third-strongest for issuance over the past two years, according to Dealogic, a data provider. Mitsubishi UFJ sold $750m in dollar-denominated AT1s in October. This month both Barclays and Société Générale have issued their own. Even UBS recently sold $3.5bn in AT1s—under the same Swiss regulatory regime that annihilated those of Credit Suisse.

An unkind columnist might wonder if all this is because investors have the recall capacity of goldfish. Amnesia is certainly tempting when such tasty returns are on offer. Euro-denominated AT1 bonds currently offer yields of around 9.6%, up from a nadir of 2.8% in late 2021. Feeling the warm glow, many seem keen to put their hands to the hot stove again.

The more charitable view is that investors have decided the Swiss blow-up was idiosyncratic. Regulators elsewhere in the world rushed to insist that their banks’ AT1s would never be subordinated to shares. And the market seems to be functioning well despite its springtime panic. The vast majority of AT1s facing call dates—when banks can, but do not have to, redeem and repay the bond—have been repaid. That indicates good financial health, and an ability to issue more bonds. According to GAM Investments, an asset manager, 92% of AT1 bonds with a call date in 2023 have been redeemed, barely down from the long-run rate of 94%.

The phoenix-like recovery of the AT1 market also says something about the state of financial markets more broadly. On both corporate bonds and stocks, the compensation on offer for exposure to losses is miserable. For American shares, the equity-risk premium—a measure of the excess expected return for buying risky stocks instead of “safe” government bonds—has slumped to its lowest level in decades. That does not mean that stocks will fail to beat bonds in the long run. But it does mean that the earnings that analysts currently expect offer paltry yields in return for risk.

Something similar is true in the credit market. Corporate debt currently offers measly returns in exchange for the risk of default. In both the investment-grade and junk-rated markets, spreads—the extra yield investors receive above those of Treasury bonds—are below the average level over the past ten years. As recently as the beginning of 2022, American junk bonds offered marginally higher yields than dollar-denominated AT1 bonds. But today, at 10.1%, the yield on a dollar AT1 is 1.6 percentage points above the yield on the equivalent junk debt.

Banks have sold $51.3bn-worth of AT1 bonds so far in 2023. If they issue another $3bn before the year is out, that will beat the total issuance figure for 2022, despite the seizure the market suffered in March. If the rewards for taking risk in other asset classes were less stingy, it is difficult to imagine that demand for AT1 bonds would have recovered so rapidly. It might not have recovered at all.

The next year will be a pivotal one for the market. Around $30bn of AT1 bonds face their first call dates in 2024. But if surprisingly low corporate-bond spreads and an eye-wateringly expensive stockmarket persist, the instruments are likely to remain in demand among investors searching for returns. A sober assessment of how AT1 bonds would fare in another bank collapse may have to wait until the alternatives look a little less dispiriting. ■

Read more from Buttonwood, our columnist on financial markets:
Ray Dalio is a monster, suggests a new book. Is it fair? (Nov 16th)
Forget the S&P 500. Pay attention to the S&P 493 (Nov 8th)
What a third world war would mean for investors (Oct 30th)

Also: How the Buttonwood column got its name