Investors who profited from high-risk bonds created after the financial crisis are now confronted with a new reality: they may not receive their payments.
These bonds, known as AT1 bonds or perpetual bonds, were typically sold by banks with a repayment option triggered after five years. In the past, investors received their money back, and banks issued new bonds. However, some banks are changing their approach.
This emerging trend underscores the vulnerability of the global financial system as it grapples with soaring borrowing costs and the repercussions of the war in Ukraine.
The near collapse of Credit Suisse earlier this year had a significant impact, leading to a government-backed rescue that eliminated billions of dollars’ worth of AT1 bonds. This event shocked investors and increased the cost of issuing such bonds for other banks.Now, smaller banks are opting not to repay their bonds, much to the dismay of investors. Instead, they are extending the bonds beyond the initial five-year period and paying interest on them.
Raiffeisen Bank International (RBI) situated in Austria, for instance, focuses to skip the choice to reimburse its 650 million euro (about $716 million) AT1 bond in this month.
The spokesperson for RBI stated that the bank is committed to calling and refinancing the bond as soon as it makes economic sense.
Deutsche Pfandbriefbank and Aareal Bank, two German banks, have also avoided repaying 300 million euro bonds each earlier this year, choosing to keep them open.
These actions by banks highlight how the aftermath of the Credit Suisse AT1 bond losses continues to impact the market, which is estimated to be around $275 billion.
Investors, taken by surprise, have become more cautious about investing in AT1 bonds issued by mid-sized banks.
The yields on these bonds have experienced a significant increase, surpassing 10%, compared to the previous level of around 8% before the Credit Suisse rescue. This surge can be attributed to investors seeking a greater premium to offset the amplified risk involved.
This development has resulted in a division within the AT1 market.
Alessandro Cameroni, a portfolio manager at Lemanik, described the market as splitting. He noted that larger banks, conscious of the stigma associated with not repaying bonds, are likely to act differently.
However, smaller issuers, who would like to repay investors but face growing challenges, find it increasingly difficult. Schroders’ fund manager, Peter Harvey, observed that the stress has created a rift between big strong banks and weaker institutions, suggesting that more extensions are expected, much to the displeasure of investors.
Investors holding RBI’s bond no longer anticipate repayment in mid-June since the bank missed a deadline to announce its repayment plans. RBI cited the higher cost of issuing new bonds as a factor in its decision.
These AT1 bonds were originally designed to assist banks in absorbing losses and contribute to their capital buffers. However, investor interest in these bonds has diminished.
According to Invesco ETF, which tracks the market, AT1 bond prices reached three-year lows during the recent banking turmoil.
The current prices in this multi-billion-dollar market indicate that investors anticipate only a fraction of the bonds to be repaid as usual, as reported by investment manager Federated Hermes.
While some major banks, such as UniCredit from Italy and Lloyds from Britain, have repaid their bonds, more repayment milestones lie ahead. Societe Generale, UBS, and Santander, based on their statements, face calls on debts totaling $3 billion, $2.5 billion, and $2.3 billion, respectively, within the next 12 months.
This situation presents a dilemma for banks that need to borrow or refinance their obligations.
The shifting landscape of AT1 bonds and the uncertainty surrounding their repayment have cast a shadow over the market and raised concerns among investors and financial institutions alike.
According to analysts from Morgan Stanley, European banks will have to issue over 400 billion euros of AT1 debt in the next three years.
However, the steep expenses associated with these bonds may discourage some banks from pursuing this option.
Karsten Junius, the chief economist at J. Safra Sarasin, mentioned that the alternative of increasing their equity would be even more expensive.