Active Thinking: Capitalising on extension risk in AT1 bonds

Atlanticomnium’s Gregoire Mivelaz and Romain Miginiac provide insights into how they manage extension risk and its potential impact on AT1 bond performance.

27 June 2024

Investors are constantly seeking avenues for higher returns. While some options come with increased credit and interest rate risks, we believe Additional Tier 1 contingent convertible bonds (AT1 CoCos) and other subordinated debt stand out in terms of outpacing other high-income credit instruments. This yield compensates investors for the risks associated with the cyclical nature of their yields and spreads. The market's technicals are currently strong: clear call and issuance requirements lead to a balanced market, and the reinvestment of coupons results in a net negative supply.

What is extension risk and why does it matter?

AT1 CoCos are perpetual bonds which typically have call dates every five years. Extension risk is basically the risk that the issuer may not redeem the bond at the first call date, usually callable at par. For investors, this is unfavourable because it means holding the bond for an extended period, contrary to a five-year term. Why does the price of the bond drop when extension risk is perceived to be high? It is because investors demand a higher yield to compensate for the additional risk associated with the longer holding period. For instance, the difference in yield required between a five-year bond and a perpetual bond reflects the increased compensation needed for the risk over a more extended period.

Chart 1: Simplified example, new AT1 CoCo with a call date in 5 years, price of 100%, coupon/yield of 5%

In an ideal situation, issuers would redeem these bonds at the first call date if it can reissue a new AT1 at a lower cost. However, negative market sentiment and the high issuance costs can lead to concerns that the bonds will not be called, making bond prices more sensitive and behaving like perpetual bonds, rather than five-year bonds.

Consider a new AT1 CoCo issued with a 5% coupon, implying a 5% yield at par, with its first call date in five years. If market conditions worsen, leading to increased risk premiums and wider spreads, the required yield might rise. For instance, if the issuer needs to pay 7% to issue a new five-year bond, the price of the existing bond, if still priced as if it will be called at the first called date, would decrease to approximately 90% of the original bond price. This price reflects the investor’s expected five years of coupon payments plus the necessary capital appreciation to match the increased yield requirement. But as investors now worry that the existing bond might not be called, investors further reprice this bond from next call date to maturity, which means an additional price drop from 90% to 71%.

However, the market is sometimes inefficient, as participants overestimate the likelihood of bonds not being called at first call date. We believe that the pricing of extension risk tends to be extremely inefficient, which is an opportunity for us active managers as it allows us to capitalise on the market’s tendency to overprice this risk.

Extension risk is a great buy or sell indicator

Chart 2: Percentage of AT1 CoCo market priced to perpetuity

Extension risk is a significant indicator for buy or sell decisions, in our view, particularly in the face of adverse events, such as Brexit vote in 2016, Trade-tensions between the US and China in 2018, Covid Pandemic in 2020, Invasion of Ukraine in 2022 and concerns about US regional banks as well as Credit Suisse in 2023. This risk is reflected in the percentage of AT1s priced to perpetuity, indicating market expectations that they will not be called. Typically, this percentage peaks around 100% during such negative events, driven by concerns that the high costs for issuers to issue new bonds will prevent the calling of existing ones.

For the chief financial officer (CFO) of a bank, the decision to call or not call an AT1 with a call date in 2027 or 2028 is not influenced by current spread levels. The decision-making process typically begins three to nine months prior to the call date, implying that the market assumes current negative conditions will persist for the next few years. European issuers are known for their bondholder-friendly approach, believing that managing relationships well can lead to reduced funding costs over the long term. This was exemplified when Barclays paid an additional 1% coupon in 2022 to refinance an AT1. Issuers have been proactive in using excess capital to call AT1s, waiting to reissue until market conditions are favourable. This strategy is supported by the historical trend where 95% of AT1s were called at their first call date, a pattern that continued through 2020, 2022, and 2023, demonstrating a strong track record of calling by issuers. ¹

Extension risk is a measure of market sentiment, particularly in response to extreme events. When 100% of bonds are priced to perpetuity, it suggests that the market has overreacted and the downside risk is already factored in, presenting significant upside potential. This was the case in 2023 following the Credit Suisse event, where most AT1 Cocos re-priced to perpetuity, indicating an aggressive positioning opportunity in AT1 CoCos due to their high potential upside. Conversely, when the percentage is close to 0%, as seen in mid-2021, it implies the market is priced to perfection, with limited upside and greater downside risk, warranting a conservative positioning. Active management is key: taking advantage of market inefficiencies with the aim of generating alpha.