AT1 or contingent convertible bonds – and increasingly, sukuk – have grown in popularity throughout the Middle East since 2013, when ADIB and Emirates NBD opened the market with their Tier 1 capital instrument. All told, about 17 GCC banks hit local and international markets to raise over US$12bn in Tier 1 capital in 2016.
Last year also saw a sale of the largest Tier 1 notes in the region to date, QNB’s whopping QAR10bn (approx. US$2.75bn at the time of issuance) privately placed perpetuals, which the bank used to help boost its capital after buying National Bank of Greece SA’s Turkish unit for €2.75bn (US$3bn), Finansbank.
That deal was set against a backdrop of record bond volumes recorded across the Middle East, with persistently low oil prices and tighter regional liquidity spurring borrowing on a massive scale.
But despite the slow ramping up in supply over the past few years, investors and observers have started to question whether AT1s – which have a distinct investor base and are actually quite complex for a range of reasons – will remain attractive.
When AT1s first came to emerging markets, they were largely seen as a great way to pick up high quality assets with extra yield, and for Middle East issuers it was initially a leveraged play reserved mostly for private banks – with an investor base dominated by many of the same institutions. They were high-beta, and sometimes rates-correlated, instruments, but they have since evolved into a fairly attractive proposition for some.
The fact that the interest rate paid to investors on these instruments resets after a number of years means that for longer-dated issuances, there is to some extent a dislocation between interest rate risk and overall tenor – a potentially valuable feature in today’s relatively erratic markets. That domestic issuers have also started structuring these instruments in sharia-compliant formats adds to their appeal for many investors targeting the region
“These are new and complex instruments but the way they have performed, particularly more recently, has added to their appeal. Some of their resilience to the rise in rates, for instance, reflects what would be expected of their equity-like characteristics. That is ultimately what they’re supposed to do – introduce some equity risk into a bond – but they are still marketed and sold to a fixed income audience with an evolving understanding of what they are and what risks they hold. The difference in the reaction of some of the same instruments to the rise in rates in 2013 versus the second half of 2016 is an example of that evolution” explains Sharif Eid, a global Sukuk and GCC debt portfolio manager at Franklin Templeton Investment ME. “These bonds and Sukuk aren’t for everyone.”
Investor Learning Curve
The heterogeneous banking environment, coupled with the complexity of knowing the ins and outs of how their bail-in or conversion mechanisms work, hasn’t evolved all that much since their introduction. This factor continues to cause headaches for investors and could stymie demand.
In Qatar for instance, all banks have been required to submit Basel III LCR and NSFR liquidity measures to the Qatar Central Bank (QCB) on a monthly basis since August 2012. Any bank that deviates from the targeted minimum limits of LCR or NSFR is required to provide a reasoned account of their liquidity positions, and provide detailed plans on how they expect to make up any shortages and bring the ratios above the mandated thresholds.
The Central Bank of Oman implemented similar reporting measures around the same time as the QCB, and in January 2015 the LCR requirement begun being phased in. The initial requirement is a minimum of 60% for 2015, with this limit rising 10% each year until January 2019, the formally agreed target for full implementation, when banks will be required to meet the 100% LCR threshold.
Saudi Arabia has arguably been the most proactive in the region in terms of adoption. The Saudi Arabian Monetary Agency (SAMA) has undertaken a number of noteworthy initiatives designed to strengthen the prudential framework relating to bank capital. SAMA issued the final rule on Basel III risk-based capital in December 2012 to implement the first phase of Basel III (which took effect in January 2013).
A number of new rules and policies were also put in place in October and December 2012, particularly on capital requirements for bank exposures to central counterparties (CCPs). Several aspects of SAMA’s framework are more conservative than the Basel framework, according to a report penned by the Bank For International Settlements (BIS).
The UAE has yet to formally adopt Basel III rules despite informal directives from the country’s Central Bank, and repeated delays to formal adoption.
“If you look at EMs broadly, you have AT1 structures from close to 17 countries, and each region has different frameworks, different triggers for the point of non-viability. You need to understand how these elements impact bail-in mechanisms and the like. This makes it much more complicated to assess the true risk of investing in these instruments,” explains Sergey Dergachev, Senior Portfolio Manager Emerging Markets Debt, Union Investment Privatfonds.
“AT1s have been a great yield enhancement play this year. In many cases, they are like a senior bond but with three to four hundred basis points pick-up. But you need a very sophisticated regulatory risk framework to understand how to invest in these properly.”
Dergachev says there are signs emerging market investors are coming to grips with the asset class, learning from the growth of Tier 2 capital instruments. About 10 years ago these instruments were relatively scarce in EMs, but today almost every EM jurisdiction has seen or continues to see regular Tier 2 supply come to market.
“I think we are likely to see AT1 supply plateau in the Middle East after a few years of increasing volumes,” observes Aymeric Arnaud, a DCM banker at Societe Generale Corporate & Investment Banking. “It is not a problem with the market – the market can absorb additional supply. But the fact is that we have seen relatively subdued loan growth in the Middle East and we have regional banks that are relatively well capitalised on average.”
While there are some nuances across the region, GCC banks tend to have relatively sound loss absorption buffers, while a drop in overall deposits have led bank lending growth to decrease from upwards of 6.6% to 5.8% in 2016, according to data from Moody’s. Growth in MENA is set to accelerate through 2017 and 2018 following the bottoming out of oil prices in 2016, according to the IMF, which will see banks accelerate lending by as much as 0.4% in the first half of 2017.
“In Saudi Arabia, we have seen capital ratios gradually grind below regional peers, meaning we could see more supply from the country’s banks. But while most of that supply has previously been absorbed by the domestic market, the liquidity situation in the country has left many observers wondering whether these banks will open up to the international capital markets for hybrid capital instruments.”
“In Qatar you have a very similar situation – with AT1 supply strictly done in the domestic market so far and questions about whether that will continue. The international market would certainly offer to Qatari banks an interesting opportunity for diversification,” Arnaud says.
But some observers have suggested the asset class may be in the midst of a kind of existential crisis – not just in MENA. AT1s, often referred to in Europe as Contingent Convertible or ‘CoCo’ bonds, were born in Europe as a way of satisfying Basel III and government requirements related to global financial stability.
Ultimately, those instruments were intended to be adapted to other developed markets, but that did not happen. US banks, among the largest in the world, have so far abstained from issuing AT1 capital instruments.
At the same time, crises at a number of banks in Italy and Germany – Montepaschi and Deutsche Bank in particular – and the subsequent performance of their credits created concern and confusion among investors about when and how issuers can halt coupon repayments.
That level of uncertainty need not be beckoned by a crisis, and can sometimes catch investors out. In November 2016, Standard Chartered surprised the credit market by announcing that it would not redeem its old-style Tier 1 bonds due January 2017, prompting them to drop about 151bp after the call date.
Others have raised questions about the utility of these bail-in mechanisms given how untested they are. The only European precedent for a bail-in, set recently, was when Ukraine’s largest lender, PrivatBank, was nationalised in a bid to stave off collapse – but it nevertheless saw close to US$595mn in Eurobonds being bailed-in and converted to shares as part of the government’s bid to restructure the struggling lender; the move has already prompted speculation that a legal challenge from bondholders could be in the offing. Needless to say, bail-in mechanisms were designed to help avoid bail-outs.
In the GCC, these questions are becoming more urgent given the state of sovereign balance sheets in the region as well as the size and number of private, government-owned banks. Clearly, a private government-owned bank issuing these instruments, with the power to decide whether to abstain from coupon payments, raises conflict of interest concerns.
Beyond that, it could see sovereign risk passed through the banking system and the real economy more quickly than would otherwise be the case.
“There is a regulatory backdrop for these instruments that needs to be addressed before their proliferation can continue,” Eid says. “In the GCC, one could make the case that this question hasn’t been fully understood nor appropriately clarified for the benefit of various participants. An important consideration in introducing bail-in mechanisms has been to protect taxpayers; particularly after public dissatisfaction with their European states’ involvement in rescuing parts of the banking sector. These considerations are clearly different in the GCC, where there is no taxation, so what is the point of these instruments? The region does not seem to be an ideal place for this subset of issuance to grow and surprises can prove costly for the investor that takes these risks lightly.”