By now many, if not all professional Canadian investors have heard of AT1 bonds or Limited Recourse Capital Notes, as they are referred to in Canada. Recently, Canadian financial institutions have issued billions in LRCN at the expense of retiring preferred shares. Unfortunately for both AT1 and preferred share investors, March 2020 was a particularly ugly month. Fortunately, for the sub-advisor to the Relevance Diversified Credit fund, Astra Asset Management, they used the period of dislocation in AT1’s to buy, amongst all the selling. Astra’s thesis was that (i) global financial institutions entered Covid with strong balance sheets (ii) banks would likely be the conduit for government stimulus which would benefit them and (iii) stimulus money would keep many companies afloat until the pandemic passed, also supportive to bank loan loss ratios.

Background

AT1 bonds primary purpose is a readily available source of capital for a firm in times of crisis. Historically tier 1 capital financing was allowed only through the issuance of common and preferred equity, but that changed post the global financial crisis. The benefit of issuing AT1 bonds vs preferred equity is the ability to use pre-tax interest income rather than after tax dividend income, reducing the cost of financing tier 1 capital. Given the cost advantage, global banks have been issuing AT1’s for over a decade but they did not exist in Canada until RBC issued the first on June 1st, 2021. At Relevance, we have previously argued that the ability for Canadian active managers to deliver alpha is limited to a degree, by the lack of market, security and structure breadth within Canadian capital markets. This is just one example of many examples.

The opportunity

As the risks of Covid started to take hold in February and March of 2020 asset prices dropped precipitously across risk and non-risk assets. The risks of permanent loss of capital were real. Astra entered March 2020 with over 36% cash in their portfolio and wasn’t convinced financial markets would return to normal as quickly as they did. With that said, one area they knew had entered the crisis with financial strength was global banks, and they decided to act.

Despite the financial strength of the banks, their securities fell in sympathy with other assets. There were even fears that Covid would spark another financial crisis, disproportionately impacting banks. Astra had a different view. They felt that not only had banks fortified their balance sheets, they were also likely to benefit from being the conduit of global government stimulus. Based on this view and the price action of bank bonds, Astra started to accumulate a position in U.S., European and U.K. AT1 bonds.

As noted above Astra went from a 0% to 11% stake in European and U.K. AT1 bonds in mid March. In late February these bonds traded near or above par and fell over 40% in less than a month. While Astra initially experienced some losses, government reassurances quickly turned sentiment around and the bonds surged.

Since March of 2020 the banks have proven that, not only did they enter the pandemic with strength, they also benefited from the flow of government stimulus as Astra expected, as well as capital market gains. Tier 1 capital ratios have surpassed pre-pandemic levels, further reducing the risks that AT1’s get converted to equity. As of the end of July, the spread between RBC’s AT1 bond with a yield of 4.75% and the broad bond and high yield market looks very attractive. Astra’s view is that the scale of government corporate bond purchases has pushed corporate spreads to levels that no longer compensate investors for the risks that they are assuming. They view AT1 bonds as less risky than the broad corporate market given their attractive relative yields.

Based on Relevance Wealth July 2021 competitive intelligence report, active management within credit and fixed income has delivered significant results for clients relative to traditional fixed income strategies. Given the current yield and spread environment we are recommending increased allocations to active strategies from experienced, credentialed and successful fixed income managers to allow clients to achieve the rates of return they require for retirement, at a level of risk they are comfortable with.

Are More Options Better? For Skilled Alternative Managers, Yes.