"Stability Miracle" in the Turmoil of the Bond Market: Why Are High-Risk AT1 Bonds More Resilient?

Recently, the bond market has faced a wave of sell-offs, revealing an unusual phenomenon: some of the highest-risk and most complex types of bonds have, paradoxically, been the most stable. Data on the rolling 10-day volatility shows that the volatility of bank-issued subordinated bondsAdditional Tier 1 (AT1) capital bondsused to meet regulatory requirements is 75% lower than that of investment-grade corporate bonds. In contrast, mainstream bonds, especially long-term government bonds, continue to be under pressure from multiple factors such as inflation concerns, fiscal difficulties, and a flood of corporate bond supply. The relative calm of AT1 bonds highlights investors' behavior in chasing returns within this asset class. Earlier this year, the struggling Credit Suisse fully wrote down $17 billion worth of AT1 bonds, momentarily putting this type of bond in the spotlight. At that time, the volatility of AT1 was ten times that of investment-grade corporate bonds; during earlier tense periods in Iran this year, its 10-day rolling volatility was nearly double that of the latter. "AT1s have very low sensitivity to interest rates and react very little to changes in macro-economic conditions," said Romain Miginiac, fund manager and head of research at Atlanticomnium SA. He joked that AT1s have now become a kind of "risk-free asset," and added, "This claim may be a bit exaggerated, but the fact is, if you look at the performance over the past 12 months, they have been incredibly stable." High yields but low volatility: How to explain the unusual performance of AT1s? There are solid reasons behind the stability of AT1 bonds. A survey released by ABN Amro Bank NV this week showed that approximately 80% of investors surveyed can meet their total return targets solely through coupon income. Shanawaz Bhimji, the banks head of credit strategy, stated that investors whose return expectations fall below the current yield level of AT1s "will continue to maintain high buying interest." With rising yields on AT1 bonds issued by large global banks, and as government bond rates increase, their return attractiveness has further strengthened, leading to an influx of investors into this market. Since November of last year, the number of fixed-term funds aimed at retail investors that invest in perpetual AT1 bonds has nearly doubled. Moreover, flexible allocation funds, which have no investment restrictions, are actively buying AT1s as fund managers seek higher returns amidst elevated valuations in the credit market. AT1 bonds are classified as "high beta" securities, meaning theoretically their prices rise more than the overall bond market in upturns and fall more severely in downturns, due to their higher risk and loss-absorption characteristics. Thus, their resilience in the recent turbulence of the bond market is quite rare. The high yields partially explain this unusual phenomenon and are also a critical pillar supporting stable demand. AT1 bonds offer more generous coupons to compensate investors for the additional risks they bear, including the risk of coupon payments being skipped, uncertain repayment timelines, and the possibility that AT1 holders may suffer losses first in the event of a bank failure. Data indicates that the Bloomberg Global Contingent Convertible (CoCo) Bonds Index has an average yield of approximately 5.7%, while the investment-grade corporate bond index yields less than 5%, and the government bond index yields around 3.7%. It is understood that AT1 bonds fall under the category of CoCo bonds, which emerged after the global financial crisis. Their core function is to absorb losses when banks are on the brink of bankruptcy, thereby alleviating the financial burden on the government and taxpayers, and preventing crises from spreading through the financial sector. Spreads fall to historic lows as complacency clouds the AT1 market However, the hunt for high yields among investors has led to a buildup of risks. The key metric that measures whether issuers will repay bonds on the first call datethe AT1 spreadhas narrowed to a record low. Last week, the global CoCo index spread fell below 200 basis points for the first time. Miginiac noted that investors chasing yields amid such narrow spreads are "very complacent." Recently, a dollar-denominated AT1 bond issued by BNP Paribas set a record for the narrowest reset spread in history for that currency. Previously, several American banks, including Goldman Sachs and BNY Mellon, also issued preferred shares this summer at the narrowest spreads seen since the post-crisis eratools primarily used by U.S. banks to supplement their AT1 capital. Luca Evangelisti, an investment manager at Jupiter Asset Management, stated, "The demand for AT1 assets remains very strong." He believes that whether from new investors or experienced CoCo holders, their buying behavior may support subsequent issuances, "As we've seen so far this year, order books can continue to be several times oversubscribed." However, he also mentioned that due to the excessively narrow reset spreads and limited discounted new bond issues, he is becoming "increasingly selective" in his investment choices. Meanwhile, Man Group has warned that AT1 investors are "thoughtlessly" pouring into this field without adequately assessing the risks they are taking on. Nonetheless, European banks, which are the main suppliers of AT1 bonds, have significantly improved their balance sheets, and investors no longer feel concerned about the sector's stability. So far this year, European bank stocks have even outperformed the "Magnificent Seven" tech stocks in the U.S. Such fundamental improvements are expected to mitigate shocks when future market pressures arise. "Historically, the correlation between AT1s and broader risk-averse behaviorwhether in stocks or government bondsmay not reliably guide future performance, especially when the trigger factors are not directly related to the banking sector," Evangelisti remarked.