AT1 market hits rock bottom, puts sector in jeopardy

* AT1 bonds crater

* Issuance plans on backfoot

By Alice Gledhill

LONDON, Feb 9 (IFR) - The Additional Tier 1 market is suffering its worst sell-off since opening in 2013, scuppering banks' ability to continue using the instruments to shore up their balance sheets and raising fresh doubts about the depth of the investor base in Europe.

While AT1 bonds proved largely resilient to 2015's volatility and emerged as one of the year's best performing credit segments, the sector has taken a nosedive in 2016 with excess return down 8.8% year-to-date versus Treasuries, according to CreditSights.

European banks are expected to price around 30bn-40bn of AT1 capital this year, but with yields at such prohibitive levels there is little chance of issuance, delaying funding plans and storing up a potential bottleneck of supply.

"There's something of a vicious circle: if investors see valuations going down, they become more nervous and sell," said Roberto Henriques, European credit analyst at JP Morgan.

"No issuer, even with the best intention, could issue AT1 in current market conditions and I doubt they would wish to validate the current secondary market levels."

Even AT1 securities from names traditionally considered as safe havens have been hit. A 1.5bn HSBC deal has dropped almost 10 points, sending its yield rocketing to 8.19% from 6.45% in early February.

"The problem right now is that a few idiosyncratic cases are having a contagion effect on the rest of the sector," said Andrew Fraser, investment director for fixed income at Standard Life Investments.

"I am not sure the AT1 market is open right now and I am also not quite sure how it will open."

Deutsche Bank (Other OTC: DBAGF - news) in particular has drawn scrutiny due to fears that its Available Distributable Items (ADIs) - from which AT1 coupons are paid - could fall short, driving its bonds to new lows this week.

While the notes rebounded up to four points following a statement from Deutsche on Monday evening, they were still bid in the high 60s to low 70s on Tuesday afternoon.

But Deutsche is not the only bank to see its bonds suffer dire losses as broader concerns around the European banking sector escalate. The fact that mandatory restrictions to discretionary distributions came into play this year is also starting to bite.

Standard Chartered (BSE: 580001.BO - news) 's US dollar 6.5% perpetual non-call 2020s have tumbled to a cash price of 83.2, for example, while UniCredit (EUREX: DE000A163206.EX - news) 's euro 6.75% perpetual non-call 2021s are bid at 74.2, according to Eikon prices.

FRAGILE INVESTOR BASE?

The sell-off has stoked fears that the investor base for AT1 debt in Europe may be more fragile than was thought almost three years on from BBVA (Amsterdam: BA6.AS - news) 's inaugural trade.

"The risk for AT1 is a scarcity of potential marginal buyers in Europe away from specialised funds as retail can't buy and insurance is sitting on legacy debt. Every hint of market fear will push prices down until there is a stable, natural investor base in place," said Gildas Surry, partner and senior analyst at Axiom Alternative Investments.

Analysts fear that high yield investors, early buyers of AT1 paper, cannot be relied upon to support the asset class because it is not their natural domain.

"It is the first thing a traditional high yield fund would sell," said Christy Hajiloizou, a credit analyst at Barclays (LSE: BARC.L - news) .

Hedge funds, meanwhile, were notably absent from new trades earlier this year following high profile outflows and closures.

"The concern now is whether this is temporary or not and whether AT1 is falling into historical pockets of demand and a high beta proxy for market sentiment," Hajiloizou said.

BUMPY ROAD

The fact that primary issuance must resume at some stage may be compounding the sell-off further as investors hold on for the lofty new issue premiums that banks will likely have to pay.

Even (Taiwan OTC: 6436.TWO - news) so, there are rays of light amid the gloom. Some bonds have weathered the storm better than others and current levels can present an attractive entrance point.

"In corporate bonds, financials remain our favoured sector and we see a lot of value in certain issues, supported by conservative management and a very strong capital structure," said Mark Dowding, co-head of investment-grade debt at BlueBay Asset Management.

In contrast to the past, when AT1 bonds have broadly moved in line, investors are anticipating an ever greater divergence in returns within the sector.

"2016 will be a year of differentiation in the asset class as investors now discount the specific business model, the point where the bank stands in the balance sheet adjustment cycle and last but not least the specifics of national accounting frameworks, for the right reasons," added Axiom (OTC BB: AXMM - news) 's Surry.

But ongoing confusion around the interplay of capital buffers and coupon payments will continue to weigh on the sector, he warned.

"Until the regulatory rules are clarified, and European authorities communicate around them in a consistent and coordinated manner, the road will remain bumpy." (Reporting by Alice Gledhill, editing by Helene Durand, Julian Baker)