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October 10, 2017

How global regulation has created brand new investment classes already approaching $2 trillion in value

Jonathan Zenios

The introduction of the Basel 3 reforms has resulted in significant changes to the way banks fund themselves including the types of instruments issued. Why should markets care and what does this mean? As a result of these regulations entirely new asset classes have emerged known as Additional Tier 1 (AT1 or so called ‘CoCos’) and Tier 2. These instruments are subordinated to senior bank debt providing a yield pick-up but are senior to common equity allowing for lower volatility.

Currently there are over $1.8 trillion in instruments outstanding globally – double what was outstanding in 2013 when the reforms came into force and 10x pre-crisis levels in 2006 when total issuance was just under $160 billion. In comparison there is around $8 trillion currently outstanding in publicly traded common equity from banks. End state for a typical well capitalized bank is c. 8-10% equity, 1-2% AT1, 2-3% Tier 2 and issuance levels reflect banks getting to this as BIS fully loaded ratios come into force.

A tenfold increase in the amount of securities issued since the crisis hasn’t gone unnoticed. More and more investors are looking at AT1 and Tier 2 instruments for diversification, a Morgan Stanley survey of European investors outlined that 63% of respondents described their AT1 holdings as a core part of other long-term holdings[1]. This also isn’t just CoCo or pref share funds, over 60% of AT1 volume holders in the survey are asset managers – most of which are not primarily HY focused.

This result shouldn’t be surprising, financials are arguably better capitalized than ever[2]. The deleveraging of banks will continue as capital requirements are phased in at fully loaded levels – further reducing balance sheet sizes which should also be good for debt investors. Whilst the low interest rate environment has not helped banks achieve their ROE targets, with the exception of some of the weaker or periphery banks this is primarily an issue for equity holders rather than having a meaningful impact on solvency.

In the high yield corporate bond market, subordinated instruments ranked similarly to AT1 and Tier 2 make up around $1.2 trillion outstanding. Interestingly it appears ghosts from 2008 are still in the mind of the market, where there’s a significant yield pick-up for financials – total return levels are c. 2x higher for the European CS CoCo index vs European high yield corporate credit with the same average credit rating[3].

On all measures of risk and liquidity banks are much safer holding substantially more capital on lower risk balance sheets. Regulators are also playing an active role (e.g. in clarifying rules on coupon payment priorities) and are determined to make the new AT1 and Tier 2 asset classes a success. This is resulting in an interesting relative value assessment versus traditional HY corporate and bank equity markets – investors are taking notice.

[1] Morgan Stanley European Banks 2017 AT1 Survey – Results, 5 May 2017.
[2] Bank Capital. Mini-skirts and Maxi-dresses
[3] Credit Suisse, European Banks: Attractive Relative Value, 06 September 2017.
General: market data from Bloomberg 26 Sept 2017.