Born of the Global Financial Crisis, additional tier-1 securities were designed to absorb bank losses in times of turbulence and maintain financial safety at no cost to taxpayers. Despite good intentions, we’ve found AT1s to be flawed instruments that are contingently junior to common equity in practice. These complex securities are not only difficult to model relative to their standard issue counterparts, but they create a troublesome principal-agent conflict for quasi-sovereign banks. Despite the optical opportunity presented by these new instruments in the form of higher yields, the hurdles we have applied for investing in AT1 bonds have generally been higher than the market spreads to account for their binary nature and relative unpredictability.
During the Global Financial Crisis, taxpayers suffered big losses while the bank bondholders walked away with par claims in their pockets – claims that were funded by taxpayer dollars. Most shareholders walked away unharmed as well. In years since, motivated not to repeat a public bailout of private institutions, regulators have pushed banks to fund their activities with more loss-absorbing instruments. Understanding, however, that true capital is particularly costly in times of turbulence, regulators created a new instrument to correct what appeared to be an unfair distribution of losses across taxpayers, debt holders, equity holders, and depositors. Known as contingent convertible (“coco”) 1 or additional tier-1 (“AT1”) securities, this new class of subordinated bank debt was designed to ensure that junior bondholders would bear at least some financial burden in times of crisis.
These AT1 securities, now roughly $250 billion and $25 billion of notional value in developed and emerging markets, respectively, offered a simple risk/return concept. In exchange for receiving higher interest payments, AT1 investors would take on the risk that the issuing bank, should it run into trouble, may suspend interest payments, convert the bond into equity, or write the bond off altogether. In the event capital was urgently needed, regulators would be spared from tapping into public funds to finance a bailout.
But as AT1s entered the emerging country debt investable universe in 2013 and we began to catalog their features, we found that many of those features were unfriendly to investors. Most importantly, it became clear that in practice, AT1s are contingently junior to equity. This means that AT1 bondholders can incur losses before equity shareholders in many scenarios, and that such scenarios are extremely difficult to predict ex ante. This makes them difficult to model and value relative to standard bond features.