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Extra Credit: Bank Additional Tier 1 Capital Instruments

January 30, 2025
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Tier 1 Capital—the core capital comprised of shareholders’ equity and retained earnings—is a bank’s primary funding source used to run its daily operations. Common stock and preferred stock can be issued by banks to satisfy regulatory minimums and increase Tier 1 Capital.  Additional Tier 1 Capital Instruments (AT1s) are a specific form of Tier 1 Capital that are designed to absorb losses if a bank were to experience material financial stress. In Canada, AT1s are a relatively new security which was first issued in 2020 and called Limited Recourse Capital Notes. 

In this piece, we cover the structure of AT1s, some history on how the space has evolved (including its use globally), thoughts on valuation, and potential use in a well constructed credit portfolio.

What are Additional Tier 1 Capital Instruments?

AT1s are one of the most junior instruments in a bank’s capital structure as they are subordinate to deposits, bail-in debt, and non-viable contingent capital (NVCC) subordinate debt. This means they can present greater risk than other forms of bank debt, but also potentially greater return.

AT1s are subject to NVCC regulations which makes the securities convertible into common equity under two potential scenarios: (1) if OFSI deems a bank non-viable, and (2) if the bank receives a federal bailout. Notably, the AT1 securities do not have recourse to the issuing bank’s assets and only have a claim on a preferred share of the issuing bank that is held in a designated trust. 

Another unique aspect of AT1s is the legal maturity typically spans 60 years; however, they are callable every five years when the coupon is reset. If, on any given call date, it is cheaper for the issuer to call the AT1 note and refinance it with a new security, the banks will do so. If not, the AT1s will be extended. Each security has different call economics driven by the “reset spread,” which reflects the market’s perception of the issuer’s risk at the time of issuance and gives insight into the probability of whether or not the security will be called.

So why do banks issue AT1s?  AT1s replace outstanding preferred shares that were historically the main form of Tier 1 Capital which were largely held by retail investors. From a regulatory standpoint, OFSI became concerned about retail investors holding NVCC eligible securities and not fully understanding the risk, so it wanted to develop a product that was suitable for institutional investors, thus AT1s were created. Issuing AT1s rather than traditional preferred shares offers two main benefits for banks. The institutional investor base is larger and more reliable than the retail focused preferred share market, and the coupons on AT1s qualify as interest and are tax deductible for the issuer whereas dividends on preferred shares are not.

A History Lesson

Bank AT1s are not unique to the Canadian market; there is a very large global market for these securities. Each jurisdiction and its respective financial regulator have structured these products slightly differently. Notably there are differences in trigger events and loss absorption mechanism (conversion vs. write-down). For example, in Europe if Common Equity Tier 1 Capital drops to a certain level it will automatically trigger an AT1 conversion. In Switzerland, rather than these notes being converted into common equity, they are completely written down to zero. 

The risks associated with these securities were illustrated in March 2023 when Credit Suisse collapsed and was ultimately acquired by UBS. Investors holding Credit Suisse AT1s were completely wiped out while the senior and subordinate debt of Credit Suisse was assumed by UBS.

There was some controversy at the time this was occurring as equity holders, which were junior to AT1 notes in the capital structure, received compensation while AT1 investors got nothing. In our opinion, this comes back to fully understanding the terms and conditions embedded in the prospectus or bond indenture when investing in fixed income securities. Holders of the AT1 notes should have been aware that these notes could be written down to zero at the discretion of the regulator.

Potential Risk…or Reward?

The Mawer global credit opportunities strategy is not currently invested in any AT1 securities, largely due to the unattractive levels that these securities are currently trading at. Despite the risks of conversion or write-down, there still could be a price where the risk/reward of an investment is attractive.

A process that we find helpful in assessing the suitability of AT1s is comparing the spread-to-call, which assumes that the security is called at the next call date (5 years) and the spread-to-maturity, which assumes that the security remains outstanding for the entire term (60 years). If valuations were attractive, we'd see relatively elevated spreads on both a spread-to-call and spread-to-maturity basis. Currently, we don’t believe this is the case. This isn't surprising as in an overall tight spread environment; securities with higher risk characteristics typically appear the most expensive. 

-Mawer Credit Team


This blog post is solely intended for informational purposes and should not be construed as individualized investment advice, research, or a recommendation to buy, sell or hold specific securities.  Information provided reflects current views based on data available at the time or writing and may change without notice.  Mawer Investment Management Ltd. and/or its clients may hold positions in the securities mentioned, which may create a potential conflict of interest. While efforts are made to ensure accuracy, Mawer Investment Management Ltd. does not guarantee the completeness or accuracy of this information and disclaims liability for any reliance placed on the publication.  Mawer Investment Management Ltd. is not liable for any damages arising out of, or in any way connected with, its use or misuse.