In mid-August, long-term government bonds and high-grade corporate bonds continued to be under pressure due to factors such as inflation expectations, fiscal pressure, and increased corporate bond supply, resulting in significantly amplified price volatility. In contrast, bank-issued Additional Tier 1 (AT1) bonds performed relatively steadily, with volatility approximately 75% lower than that of high-grade corporate bonds. This phenomenon occurred after Credit Suisse wiped out $17 billion of AT1 bonds in 2023, at which time the volatility of these bonds was significantly higher than that of mainstream credit bonds. The market's pursuit of yield and the improvement of bank balance sheets have jointly shaped the current trading characteristics of AT1 bonds.

The market phenomenon of relative stability of AT1 bonds

Recent volatility in the bond market highlights a structural characteristic: some higher-risk, more complex bank capital instruments have exhibited lower price volatility. Market data shows that AT1 bonds have approximately 75% lower rolling 10-day volatility than higher-grade corporate bonds. Mainstream bonds, especially long-term government bonds, continue to be affected by inflation, fiscal conditions, and corporate bond supply pressures. This relatively stable performance contrasts with the historical behavior of AT1 bonds. During the Credit Suisse crisis in 2023, the volatility of these bonds reached approximately 10 times that of higher-grade bonds; earlier this year, at the height of geopolitical conflicts, their 10-day rolling volatility was also nearly twice that of higher-grade bonds. Roman Migignac, a fund manager and head of research at Atlantic Investment Company, points out that AT1 bonds are currently less sensitive to interest rate changes and macroeconomic conditions. He states that their stability over the past 12 months is nearing its limit. From a financial perspective, AT1 bonds, as regulatory capital instruments, possess characteristics such as cancelable coupons, uncertain repayment, and a high priority in the order of loss reporting in the event of bank problems, and should therefore be considered high-beta instruments. However, the recent decrease in volatility reflects a change in the market demand structure, rather than a fundamental change in the risk profile.

Yield levels and investor demand drive

AT1 bonds continue to attract inflows, primarily due to their relatively high yields. The average yield on global convertible bond indices is currently between 5.7% and 6.2%, while investment-grade corporate bond yields are generally below 5%, and government bond indices are around 3.7%. This spread compensates for additional risks such as the possibility of coupon payments being skipped, repayment uncertainty, and loss absorption order. An investor survey released this week by ABN AMRO showed that approximately 80% of respondents believed that coupon income alone could meet their total return targets. Head of Strategy Shanawaz Bimji stated that investors with return requirements lower than those offered by AT1 will continue to maintain a strong buying appetite. The amount of perpetual AT1 bonds invested in by fixed-term funds has nearly doubled since last November, and unconstrained funds have also increased their allocations in search of higher returns.

Narrowing interest rate spreads and signs of risk accumulation

The ongoing yield chase has pushed AT1 spreads to historic lows. Global convertible bond index spreads fell below 200 basis points for the first time last week, while ICE convertible bond index option-adjusted spreads were around 206 basis points, well below the historical median of approximately 385 basis points. Reset spreads for newly issued USD AT1 bonds by some banks have reached record tightest levels, and some US bank preferred shares have also seen their tightest pricing since the crisis. Structurally, an increasing number of AT1 bonds are adopting a 10-year initial call period instead of 5 years, leading to a longer duration and potentially increased sensitivity to interest rate changes. When anticipated redemption uncertainty increases, the price behavior of these instruments may resemble that of long-term bonds rather than simple credit instruments.

Limitations of the correlation between bank fundamentals and historical data

The improvement in European banks' balance sheets is a key factor contributing to the current market's relatively low concerns about AT1s. Increased capital adequacy ratios and restored profitability have reduced investor concerns about the overall stability of the sector. Nevertheless, extremely low spreads mean limited buffer against potential shocks. Any changes involving coupon cancellations, deferred redemptions, or regulatory assessments could rapidly alter pricing logic. In the current market environment, coupon income is the primary source of total return for most investors, while the contribution of price volatility is relatively reduced; however, this does not change the essential nature of AT1s as loss-absorbing instruments.