- by GJ Prasad
Thoughts and observations on an asset class which has peculiar features
What is the single most driver of AT1 valuation – equity metrics, duration, spread premia for inherent credit risks, risk premium for the varied options sold to issuer – coupon deferral, non-call, and potential trigger risks for conversion/writedown? Whilst the right answer is a combination of all of the above factors (and hence very difficult for ordinary folks to decipher) the real and more important answer seems to be liquidity risks (i.e. finding a clearing level) in terms of finding new buyers. This is especially true when markets focussed on a particular macro tail risk event (say Italian politics or EM contagion) and/or headline risk on the issuer and above-mentioned valuation metrics are thrown out of the window.
Breakdown in correlation
Plus sometimes, the correlation between equity and AT1 breakdowns as different investor bases look at them differently, making it impossible to properly hedge out AT1 price drop risks by shorting equity (in some cases adds to the pain trade as AT1 drops due to lack of buyers and equity jumps on short covering). And trading RV between issuers in AT1 has its own issues as in many cases they are not easily comparable and different issuers have varied valuation factors and RV exposes gross notional risks.
The point being that AT1 was issued to investors in good times as a nice carry trade giving decent yields (relative to risk free assets) but investors failed to appreciate the multi-layered risks in the instrument and more so on liquidity risks in terms of being able to get out (especially in size) when the tide turns.
There is only about EUR 150 billion of issuance to contend with and who knows what will be clearing level on many of these issues if we have a big risk-off event and there is a buyer’s strike. And with limited ability for the market makers to absorb this risk (due to post-financial crisis regulations to carry inventory), my concern is that the overall AT1 market is set for further downside risks (and very limited upside risks) with no where to hide.
Indeed, they will get very attractive when YTP reach 8% and above relative to owning equity. But we are not yet there.