This article first appeared in Wealth, The Edge Malaysia Weekly on April 24, 2023 - April 30, 2023
Additional Tier 1 (AT1) bonds, otherwise known as perpetual bonds issued by local banks, are investment instruments favoured by some institutional investors and high-net-worth individuals seeking attractive yields and returns.
According to information provided by the Bond Pricing Agency Malaysia and RAM Rating Services Bhd, 22 AT1 bonds were issued by local banks from June 2018 to October 2022. Their coupon rates ranged from 3.6% to 5.95%, which are more desirable than fixed deposit rates provided by the same banks.
The instrument has been further propagated by online investment platform FSMOne. Through its Bond Express platform, AT1 bonds can be acquired for as low as RM1,000 — significantly lower than the minimum RM250,000 that private bankers are asking for.
AT1 bonds have also been made available in the form of wholesale funds. Among them is AHAM Capital’s Single Bond Series, which provides investors with access to AT1 bonds issued by foreign banks with a minimum investment amount of RM10,000.
“If you look at the AT1 bonds issued by local banks, including Maybank, CIMB Bank and Affin Bank, they are very popular with high-net-worth investors. It is one of the few areas that investors can actually look at [for higher returns]. The more senior bonds [with lower returns] are not attractive to them,” says Tan Dao Hong, manager in charge of global fixed income at iFast Capital Sdn Bhd.
Individual investors tend to be attracted to investment instruments that provide returns that are higher than fixed deposits or, even better, the Employees Provident Fund. Anything beyond 5% tends to be more coveted, Tan adds.
“We deal a lot with retail investors. We know the things that they benchmark against: ‘If you can’t give me 5%, don’t ask me to buy your bonds.’ Another [benchmark] could be inflation. But this is more of a moving target,” he says.
While AT1 bonds are not as popular as shares, gold or bitcoins among individual investors, they have been more widely distributed in the market in recent years. So, when Swiss regulator Finma decided to write off Credit Suisse’s AT1 bonds last month, it came as a shock to more Malaysian investors than one might have thought.
On March 29, slightly over a week after the Credit Suisse incident, Bank Negara Malaysia announced that local AT1 bonds were ranked higher than equity holdings in the case of resolutions. The central bank added that local banks did not rely on AT1 bonds for capital, as more than 80% of their buffers comprise equities and retained earnings. While the announcement had calmed the market, the repercussions of the Swiss regulator’s actions continue to be felt by investors.
Fund managers tell Wealth that the Credit Suisse event had served as a wake-up call for investors on the risk of investing in AT1 bonds. While chasing higher returns, they may have forgotten the old adage that there is no such thing as a free lunch — higher returns always come with higher risks.
“You can be either a hero or a zero. For fund managers, you could be a hero sometimes when nothing bad happens. To put it simply, say, a more senior bond gives you a 4.5% coupon rate while the AT1 bonds give you 5%. Are you going to take on the additional risk for the 0.5% difference? If you do and nothing bad happens, you are the hero,” says Siaw Wei Tang, group chief investment officer of Opus Asset Management Sdn Bhd.
Some institutional investors have questioned whether AT1 bonds issued locally are properly priced to reflect their underlying risks. With five AT1 bonds expected to be called/redeemed this year, fund managers are looking closely to see whether investors will get back their principal on the first call date of these bonds.
It would also be interesting to observe which bank will issue the next AT1 bonds and at what rates, they say.
AT1 bonds are known by different names in different regions. They are called contingency convertible bonds (CoCo) in Europe, as in the case of Credit Suisse. Locally, they are widely perceived as perpetual bonds (perps) issued by local banks.
While corporations can also raise funds through the issuance of perps, AT1 bonds can only be issued by banks, which are an integral part of the financial system of any country. The issuers are players in a highly regulated industry that falls under the purview of the central bank.
Thus, AT1 bonds are embedded with features that perps issued by corporations from other industries do not have. Among them is the loss absorption feature, whereby AT1 bonds could be partially or fully written off when the capital buffer of a bank falls below its required level, similar to what happened to Credit Suisse AT1 bonds in March.
When that happens, AT1 bonds are written down to zero and their holders would have no rights against the issuer for the repayment of the bond. They would lose their principal and any income that could be distributed otherwise.
Such a risk has been heightened by the Credit Suisse event, in which the AT1 bondholders — though ranked higher than shareholders in hierarchy — were completely wiped out whereas the shareholders received compensation.
Alternatively, AT1 bonds can be converted into the underlying shares of the issuers based on several factors. According to an FSMOne article, they include the conversion ratio and purchase price of the bonds. The converted ordinary shares may be worth significantly less than the AT1 notes. But the conversion did not happen for Credit Suisse AT1 bondholders.
A debate has been sparked across the investment community on how this risk, triggered by the Credit Suisse crisis, has been perceived by investors.
Previously, investors had thought of AT1 bonds as instruments that offered higher rates than fixed deposits, and while the money invested is not covered by the Malaysia Deposit Insurance Corporation (PIDM) and investors could lose their principal if the loss absorption feature is triggered, they had believed that this would be unlikely to happen.
AT1 bonds issued in the Malaysian market can have a tenure of up to 100 years on paper, but with a call date of five, seven or 10 years. During the call date, AT1 issuers would have the right to redeem the bonds at par and repay investors their principal much earlier than the maturity date.
The fund managers say all local AT1 bonds were successfully redeemed on their first call in the last decade or more, as not doing so would have posed a significant reputation risk to the issuer — that is, market players would have speculated that the banks were struggling financially, unbeknown to them.
It is also hard for investors to imagine banks, especially the large and established ones, facing severe challenges that would force them to write off their AT1 bonds.
But some investors are now having second thoughts after the Credit Suisse AT1 write-off. That one of the 30 global systemically important banks — as defined by the Basel Committee on Banking Supervision — could go under has increased the risk that bondholders could lose their entire capital.
Almost overnight, AT1 bonds were no longer seen as the equivalent of fixed deposits. “Investors now perceive more risk in this instrument. They might want to be compensated with higher returns. Different people have different opinions. But, all in all, investors are not going to say, ‘Give me back the same price [for AT1 bonds],’” says iFast’s Tan.
Investors who have experienced major crises, however, have not overlooked these risks. They have seen banks delay their payments to senior bondholders under extremely distressed conditions, such as during the 2008/09 global financial crisis.
Other than loss absorption, another feature embedded in AT1 bonds is distribution deferral, which means issuers have the discretion to skip interest payments to bondholders. These distribution deferrals tend to be non-cumulative in nature, which means the unpaid distribution would not accumulate and accrue any interest.
AT1 bonds also do not come with the stepped-up interest feature that perps issued by corporations have. Corporations could be required to pay holders of their perps higher rates if they do not redeem those perps on their first call date.
These are among the reasons that RAM rates AT1 bonds three notches below a bank’s rating, says Amy Lo, analyst and manager at RAM Rating Services.
“We are basically telling investors that the risk of losing your money is higher. There is the write-down [or loss absorption] feature, the subordination [towards the senior bonds] and issuers having the discretion to cancel or skip repayments.
“AT1 ratings are not the same as banks’ ratings. Let’s say a bank is rated AAA. Its AT1 bonds would be AA3. Such is the highest rating [for AT1 bonds],” she says.
So, there is a gap between how experienced investors and rating agencies perceive the risk of AT1 bonds and how individual investors in general do the same. RAM group CEO Chris Lee says many retail investors could have overlooked these risks, as remote as they may seem.
“Some would say banks will suffer a reputation risk if they don’t call their bonds or skip payments, which is true. But in terms of structure and documentation, they don’t have to [call those bonds].
“So, if you go into any of these investments, your mindset has to be, yes, they may call [the bonds], but there’s also the possibility that they may not [under extreme circumstances].”
Another risk of investing in locally issued AT1 bonds is liquidity. While the instruments fetch higher coupon rates, they are traded over the counter (OTC), where buyers and sellers ask for bond prices and execute trades over the phone without going through a centralised platform, such as Bursa Malaysia for equities. Trading activities for AT1 bonds are also scant.
Thus, prices of AT1 bonds are opaque and their bid-ask spread could be wide, especially for those with a longer tenure. Investors are expected to sell their holdings at a huge loss during bad times in exchange for cash due to illiquidity.
“Not all fund managers look at AT1 bonds, as they are illiquid. For those who do, they mostly hold them until maturity,” says Ivan Koo, senior fund manager of fixed income at AmanahRaya Investment Management Sdn Bhd (Arim).
Furthermore, not all fund managers trade AT1 bonds, as they are attached with lower credit ratings. “It depends on the fund manager’s mandate or [investment] parameters. Some fund managers would invest only in AAA-rated bonds. AT1 bonds that are usually rated at A1 to A3 would fall off their radars,” he adds.
In fact, liquidity is what concerns Opus’ Siaw the most when investing in AT1 bonds and managing bond funds. Overlooking the liquidity risk could be the reason some investors lost their money in Credit Suisse AT1 bonds.
Investors tend to look at a bank’s capital ratio when investing in AT1 bonds. If a bank can write off its AT1 bonds when its Common Equity Tier 1 (CET1) ratio falls below 5.125%, that means the higher a bank’s CET1 ratio, the better it is for investors. For instance, if a bank had a CET1 ratio of 10.125% in 2022, its CET1 ratio would have to fall by 5% for the lost absorption feature of its AT1 bonds to be triggered.
In the case of Credit Suisse, the bank had a CET1 ratio of around 14% when its merger with UBS took place in March, according to a March 24 research report published by financial services firm Morningstar Inc. That had seemed like an adequate buffer for its AT1 bondholders.
However, investors had probably overlooked the bank’s liquidity issue. Depositors were withdrawing money from Credit Suisse much faster than expected, leaving the bank with insufficient cash to fund those withdrawals. That was when the Swiss financial regulator had to step in to save the bank even when it had had a sufficient capital buffer, triggering the loss-absorption event.
A similar logic would apply to fund managers managing a bond fund, says Siaw. Some funds might invest more heavily in illiquid assets that provide them with higher returns. But without sufficient cash in hand, the fund managers would be forced to sell those assets at huge losses during bad times to fund investors’ withdrawals. He says: “At the end of the day, the price of those illiquid assets might not be the real price. People sometimes don’t price liquidity in their investments.”
Industry experts say their attention is now on which banks will call back their AT1 bonds, or offer the next issuance and at what rate.
According to RAM’s data, the 22 outstanding AT1 bonds in the market have raised a total of RM12.55 billion. Those expected to be called on June 26 and July 31 are issued by Public Bank Bhd and Affin Bank Bhd.
Three more issuances are expected to be called on Oct 18 and 23, by Affin Islamic Bank Bhd, CIMB Group Holdings Bhd and CIMB Bank Bhd.
“It would be interesting to look at how the rates will change,” says RAM’s Lee.
RAM’s Lo says industry players would also be observing whether banks redeem their AT1 bonds with new AT1 issuances and how they would replace them.
Referring to Bank Negara’s Capital Adequacy Framework, she explains that AT1 issuers are required to replace their AT1 bonds “with capital of the same or better quality, and the replacement of this capital is done at conditions which are sustainable for the income capacity of the financial institution”.
Alternatively, she says, banks could redeem their AT1 bonds if “the financial institution demonstrates, to the satisfaction of [Bank Negara], that its capital position is, and can be, sustained well above the minimum capital adequacy requirements and capital buffer requirements”.
“They usually replace them. But it will be interesting to observe the rates,” she adds.
A fixed income fund manager from a bank-backed firm concurs. “It would be interesting to see who would tap next. In my view, it’s a way of funding for banks. I don’t see it being discontinued. But the risk premium that investors ask or may ask for could be higher.”
Asked how high the premium could go, the fixed income fund manager says it is hard to say. “People might take advantage and ask for 80 basis points, or 1% or more [than its usual spread]. It is hard to predict. But I think there will be some adjustment [to the rates].”
Arim’s Koo expects the premium to go up, but not by much, owing partly to supply and demand. “I think local investors will demand slightly better yields. The local market is small. If banks like Maybank or CIMB Bank can add 20 to 30 basis points, a lot of fund managers would want it.”
Sharing a similar view is iFast’s Tan, who expects new AT1 bonds to be issued at a slightly higher rate, as the local banks are well capitalised and there are limited choices in the market for bonds. He says: “There isn’t much to go around in the local market. When new bonds are issued, they tend to be oversubscribed. Some sizeable issuances can be oversubscribed by 20 times.”
He gives the example of KPJ Healthcare Bhd, which had issued RM650 million worth of Islamic bonds recently under its RM3 billion sukuk programme, and it was easily oversubscribed by 10 times.
“It is partly the huge demand chasing after limited supply that suppresses the yields. Our [central bank] governor has also managed the pandemic situation well by raising rates gradually and progressively, thus helping the market digest the impact of inflation and more,” says Tan.
Despite the Credit Suisse event, Koo and Tan continue to favour locally issued AT1 bonds, especially the new issuances that could come with higher rates. They remain confident in the local banking system because of the high capital ratio as well as solid and sound regulations.
Opus, however, is more cautious. Ng Lee Peng, its head of fixed income, says she will invest more in the upcoming AT1 bonds only if she thinks the risk has been properly priced in.
Ng recalls that during the global financial crisis, Public Bank had issued AT1 bonds with a 7.5% coupon rate, which was more reasonable and even attractive to her. “The problem now is that the AT1s are not priced very correctly. Now that people see the risk, they will price it [higher].”
In 2022, Opus had assets under management (AUM) of RM7.1 billion. In March this year, about 0.7% of the firm’s total AUM was exposed to AT1 bonds issued by three systemically important banks, which are Maybank, CIMB Bank and Public Bank.
As for Arim, the firm allocates about 1% of its total AUM of RM6 billion to locally issued AT1 bonds rated at A1 by rating agencies, says Koo.
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