29 March 2023

Overview^1,2

What are AT1 instruments?

• AT1 instruments were created in the wake of the 2008 Global Financial Crisis by the Basel Committee. Unique to the banking industry, AT1s serve as hybrid capital instruments which are meant to help recapitalise banks in the event of insolvency or non-viability, either through equity conversion or a full write-off. As a matter of interest, most banks around the world have issued AT1 instruments.
• The Basel Committee created two categories of regulatory capital, namely Tier 1 and Tier 2 capital. Tier 1 capital comprises Common Equity Tier 1 (CET-1) and Additional Tier 1 (AT1) while Tier 2 capital acts as supplementary capital in the bank’s capital structure.
• In Europe, these types of hybrid instruments are known as Contingent Convertibles (CoCos), as they may be converted into equity instruments or written-off completely, upon a contingency event occurring.
• While the loss absorption feature is a key defining feature of AT1s/CoCos, it is worth noting that each AT1/CoCo is different, as their respective terms and conditions differ based on bank jurisdiction, write-off/conversion features, capital trigger ratios, etc.
• Holders of AT1 instruments are rewarded with higher yields compared to more senior capital instruments like Tier 2 debt and other senior debt, due to the higher risk nature of AT1 instruments.
• Under good/stable financial conditions: AT1 instruments behave effectively as bonds, paying a fixed coupon rate over the perpetual tenure of the bond (though they may be called, i.e. redeemed by the issuer).
• When the issuing bank is under financial distress/unable to carry out normal operations: The loss-absorption nature of AT1s will start to manifest themselves with rapidly falling prices, as the risk of the AT1s being ‘contingently converted/written-off’ increases.

 
What happened to Credit Suisse AT1 (CS AT1) instruments?^1,3,4,5

As was seen with Credit Suisse in recent times, the Swiss regulators decided that a non-viability event had been reached when the Swiss Government decided to provide a massive liquidity facility of up to CHF100 billion, in addition to other guarantees to facilitate the merger between Credit Suisse and UBS, Switzerland’s largest bank.

As the CS AT1 were structured with ‘capital write-off’ language in the event of a non-viability event, the CS AT1 notes were written down to zero by the Swiss Financial Market Supervisory Authority (FINMA) as part of efforts to recapitalise the bank.

Our view¹

• Our internal (Principal Malaysia-managed) funds do not invest in US and European AT1s as banks in these regions are highly complex and the regulatory frameworks in the West have often emphasised on bail-ins, that is imposing losses on investors rather than bail-outs using tax-payer funds, in the event a bank runs into financial difficulties. However, we view the situation in Asia as somewhat different, with banks that are generally less complex, better capitalised, and are more tightly regulated.
• Given the high inherent risk of AT1s as an investment class, we are extremely cautious in our approach. Before considering any potential investment, we conduct a thorough review of the specific terms and conditions governing such instruments, as well as evaluate the issuing banks' current creditworthiness and strength.
• Along with quantitative analysis of the issuing bank(s), we also take into account qualitative factors such as central bank supportiveness – which may vary by jurisdiction, government willingness and ability to support troubled banks, and the quality of the banks’ capital cushion (including the percentage of hybrid instruments versus core equity).

Sources:
¹Principal Malaysia view as of 27 March 2023.
²Bank for International Settlements as of 27 June 2019.
³Bloomberg, ECB, Principal compilation as of 20 March 2023.
⁴CNBC as of 22 March 2023.
⁵Fitch Ratings as of 23 March 2023. 

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