Crisis in Riskiest Bank Bonds Reveals a New Scandinavian Haven

Everyone wanted yield, and these bonds offered yield. Additional Tier 1 securities -- the riskiest kind of debt a bank can issue -- were the place to go for returns.

Then a few events unsettled the market. First, European regulators said conversion features that can deprive investors of coupons could be triggered earlier than many bondholders had thought. Next, Deutsche Bank AG had to reassure investors it was able to honor AT1 obligations after an analyst at CreditSights Inc. raised doubts. And in general, a horrible start to the year for some of Europe’s biggest banks didn’t help calm markets.

The upshot is that investors have started looking closely at their additional Tier 1 notes and differentiating more actively between issuers. And it seems the winners are: Scandinavian banks.

“In the general hunt for yield, everything was compressed,” said Linus Thand, chief credit strategist at Swedbank AB in Stockholm. After investors tolerated a “too small a spread between issuers,” things are now moving “in the right direction,” he says.

Handelsbanken’s AT1 yield vs Deutsche Bank’s

In the market’s early days -- AT1s have only existed since 2013 -- “investors couldn’t find yield, so they jumped on it and didn’t ask too many questions,” Thand said.

But Swedish additional Tier 1 notes have now broken away from the pack (see chart). Thand says the new spread makes sense because regulators in Scandinavia are generally much stricter, resulting in some of Europe’s toughest capital requirements. Banks in the region also beat peerswhen it comes to return on equity. (And then there’s this.)

What’s more, investors can draw comfort from knowing the market is being overseen by one of Europe’s more activist regulators. The Swedish Financial Supervisory Authority, which just this month forced banks to tighten their risk-weight calculations, says it is monitoring developments in the AT1 market very closely.

Contingent capital looks set to play a bigger role in filling banks’ regulatory buffers, according to the FSA. Coupon payments on the instruments can be halted if the issuing bank runs into financial trouble, and if losses are deep enough, the securities convert to equity or are written down, either temporarily or permanently. In January, global regulators agreed that banks can use the instruments to meet a leverage ratio requirement of 3 percent of unweighted assets, due to be implemented by 2018.

“That is the reason why issuance conditions for AT1 need to be closely monitored,” Uldis Cerps, the FSA’s executive director for banking, said in an interview. “AT1 becomes an even more important element of the capital stack” because the securities will be used to meet future leverage ratio requirements, he said.

Nordea’s AT1 yield vs Unicredit’s

“We definitely follow the market closely -- it’s important for both Swedish and European banks -- and this is something that we have to do even in the future,” Cerps said.

Thand says there “probably will be further differentiation between issuers and types of risks.” Investors are more likely to consider “how different countries choose to implement the different rules, what kinds of discretion regulators have on a national level, on triggers,” he said.

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