Do you know Luminor Bank or Landsbankinn? Probably not. Yet, the issuance of their first so-called AT1 bonds in February gathered a lot of interest from investors, highlighting a key trend: the entrance in the last couple of years of smaller names into the AT1 market. We see several reasons why investors should take notice, says Benoît Robaux, Portfolio Manager at private bank J. Safra Sarasin.
Bank contingent capital bonds, better known as Additional Tier 1 (AT1) bonds, have become a key part of the market since their introduction under Basel III in response to the 2008 financial crisis. Designed as a buffer during times of financial stress, AT1 bonds offer higher returns than traditional bonds but also carry greater risks. Their defining feature is that they are the first to absorb losses when a bank encounters financial difficulties.
A market dominated by large banks
In Europe, the AT1 market is valued at €210 billion and is largely dominated by the biggest and most established national banks. These institutions account for more than 90% of the market and typically issue AT1 bonds with a benchmark size ranging from €0.5 billion to €1.5 billion.
However, the remaining 8% of the market, composed of smaller and lesser-known banks, is far more interesting in our view. These institutions have only recently begun issuing AT1 bonds as the asset class has gained wider acceptance among investors.
A diverse range of businesses and credit profiles
Some examples of these smaller banks include Arion, Oldenburgische Landesbank, Grenke, Aareal, CCF Holding, Quintet, NIBC, Van Lanschot, and BFF. While they vary significantly in terms of business models and creditworthiness, they share several characteristics that make them attractive to investors who are not strictly benchmark-driven. But, more importantly, a few common features that make them worth a look:
- Smaller banks’ AT1 bonds typically have a size below €300 million and are less liquid, making them less suitable for investors who require flexibility. However, they often compensate for this with an illiquidity premium of 50 to 100 basis points, providing an attractive additional yield for long-term, yield-oriented investors.
- Large AT1 bonds are commonly held by traditional fixed-income funds and private investors, who tend to favour well-known names such as Santander, Crédit Agricole, HSBC, or UBS. These ‘tourist’ investors often sell their holdings in times of market stress, increasing volatility. In contrast, smaller AT1 bonds are mostly held by a stable and specialized investor base, making them less vulnerable to sharp market fluctuations.
- Many of these smaller banks are privately owned and do not have listed equities or credit default swaps (CDS). This limits the potential for speculative trading through derivatives and leverage, which can often amplify price swings for large banks.
- Smaller banks are often attractive acquisition targets for larger players. For AT1 investors, this can be beneficial, as a takeover typically leads to a price increase in the bonds.
- While careful credit analysis and selection remain crucial, many (though not all) of these smaller banks have strong capital ratios, stable business models, consistent earnings, and long-term private ownership. As a result, they are not necessarily riskier than their larger counterparts.
AT1 bonds remain a complex and niche instrument
Despite their attractive features, AT1 bonds are highly complex financial products, intended for qualified and institutional investors. Key risks include their potential conversion into equity during periods of financial instability, which can impact their value, and their subordinated status, meaning AT1 holders are among the last to be repaid in the event of insolvency.
Another defining characteristic of AT1 bonds is their perpetual nature—they have no fixed maturity date. The issuer has the option to redeem the bond at its discretion, but is under no obligation to do so.
Conclusion
For investors willing to accept the risks, gaining exposure to this niche of the AT1 market while maintaining an acceptable level of portfolio liquidity can offer compelling opportunities. Compared to AT1 bonds issued by large banks, these instruments may offer higher yields, lower volatility, and a higher average Common Equity Tier 1 (CET1) ratio.
