Hedging AT1s

If you price the option built into the bond with a reasonable model, the price implies volatility higher than the regular option market. The question is if the premium is enough or too little.

If you don’t already know what an AT1 bond is, then bank debt probably isn’t your favorite flavor. They are callable debt with a high coupon that converts to equity (or worse, nothing) when a trigger based on the bank’s tier I capital ratio is hit. There are also “sudden death AT1s” where the principal is written off.

European banks like to issue them, for reasons described below. They seem to dislike the name “cocos”, preferring the term AT1—additional tier 1—bonds. Some market color: Coco issuance has increased from about $2 billion in mid-2014 to about $90 billion in total issuance floated by year-end 2014. In 2013 coco issuance was a fraction of that. The initial trend was that only truly premier banks issued these bonds. See below for a sample.

Deutsche Bank established the preferred issuance plan, and they did it only after the German Finance Ministry ruled that coupons would be tax deductible. Issuance is somewhat tactical: a big flurry then periodic issuance on an on-going basis. Their big issue was split across three currencies: a EUR 1.75 billion, coupon 6%, ISIN DE000DB7XHP3; a USD 1.25 bn, coupon 6.25%, ISIN XS1071551474; and GBP 650 million, coupon 7.125%, ISIN XS1071551391. It makes sense for a bank, Deutsche especially.

The reason is they are highly levered, trying to fix this, and are short on equity. Equity is the capital you can do anything with. I will say this again in a different way: Equity is your loss-absorber. So they are replacing the assets to equity ratio (a totally natural, easy to measure financial stability measure) with something born of something addressing Basel III ratios that are measured from a vlookup on cell $AAB$4322 of some regulatory entity workbook. It is not easy to shore up equity, far easier for Deutsche Bank to shore up AT1 capital.

It is easier for all banks to issue AT1 in lieu of common, so there are plenty of sellers supplying. There are buyers, mostly asset managers and hedge funds. Markit even reports an index for AT1 bond called the EUR contingent Convertible Index. The deals have been as a rule oversubscribed. Draghi’s QE put an even more serious bid on them. Right now the index trades only 96 bps cheap to EUR HY, and 230 rich to subFin debt.

I wonder about this index, which needs depth, liquidity, and some level of standardization to make sense. AT1 bonds are not particularly standardized, and the trigger for these bonds is subject to accounting provisions that are, let us say, easy to manipulate. Debt recovery comes after a credit event. With an AT1 bond the event is based on a bank’s statement of its assets and liabilities. Since the trigger for an AT1 bond comes before a credit event, it benefits conventional sub debt holders. A CFO sees a bad year early enough, he could take the opportunity to make his balance sheet pristine through a ton of write-offs. The bond would trigger due to paper losses, not because of any true impairment of solvency. The bond structure would merely enforces the same debt-to-equity conversion (or in the case of principal write-downs, balance sheet shrinking) that the market would prescribe; it just makes the conversion obligatory on the AT1 holder.

The yield doesn’t seem adequate unless a buyer is convinced that there is a way to hedge the downside. To hedge it, you need to price it. Even pricing is subject to different views.

Relative pricing: Late last year, BNP used a relative pricing view. They looked at the nearest bullet bond terms and added an embedded call option that buyers assume with the terms. Implied credit spread vol was used to price the call. They showed that for even this risk buyers weren’t being adequately compensated. This method doesn’t even try to price the conversion option in the case where AT1 ratio triggered write-down. As a pricing framework, this was a mere fragment.

The other piece needed is an estimation of recovery value after the trigger, either high or low varieties. In a sudden death bond, recovery is zero. Otherwise the bond recovery is a function of the spot price of the stock at the time the trigger is breached. This involves scenarios, of which I provide an example. If you assume that the stock price at the time of trigger will be 30% of the current stock price, the recovery will be 30%. There are structures where the payout is based on a conversion price equal to a percentage of the spot price (say 50%) of the stock when the bond is issued. In this case, the recovery is 30/50 = 60%. Integrating both of these factors into a pricing model puts fair value at about 50-75bps cheap to the bond.

Given a pricing model, the next stop is a straightforward way to hedge. Consider the purpose of an AT1: a cheaper substitute for red-blooded equity. Given adequate pricing as synthetic, approximate equity, it is possible to delta hedge it with stock options. To realize the vol premium, one needs to delta hedge (and probably also gamma hedge) the bond with the underlying options on it. The implied AT1 strike is very low and depends on the particulars of the pricing model, so this is far from straightforward. If you price the option built into the bond with a reasonable model, the price implies volatility higher than the regular option market. The question is if the premium is enough or too little.

The bond pays you option premium until maturity or trigger, whichever comes first. When this volatility is sufficiently above the vanilla options of comparable strikes, you are money good. When it is not, the high leverage delta hedging this position requires with stock options gets you on the receiving end of a black swan hedge, losing money like a chump.

Another option is to sell near-the-money puts on the name’s stock, pocket the premium, and use some of these proceeds to cap losses by buying a deeply out-of-the-money put. In a downturn, the option vol premium will likely exceed the realized loss, but this is no hedge, more a funding vehicle. It could over the funding margin, though.

BlueBay Asset Management is even creating a fund dedicated to managing an AT1 portfolio. I am not sure if there is even a way to borrow and sell these securities in statute and practice. Are buyers getting ahead of themselves? Sure, but it happens all the time. Getting ahead of ourselves is the foundation of conventional behavior.

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