Invesco has announced that the $1.2 billion Invesco AT1 Capital Bond UCITS ETF (AT1), the largest ETF to track the Additional Tier 1 (AT1) contingent convertible (CoCo) bond market, has made changes to its investment approach.
Invesco believes now may be a favourable time for investors to take another look at AT1s.
Effective 31 August, the fund is now linked to the iBoxx USD Contingent Convertible Liquid Developed Market AT1 (8% Issuer Cap) Index.
The new index is broadly similar to its predecessor in that it provides access to AT1 CoCo bonds issued by European banks.
Specifically, the index focuses on the US dollar-denominated AT1 bond market, the deepest and most liquid in which European banks issue AT1 bonds. The index covers over 80% of European banks by market cap, including all of the largest issuers.
One of the main changes is that the index now incorporates a range of ESG exclusionary screens including removing violators of UN Global Compact principles as well as firms with operations linked to controversial weapons, small arms, tobacco, cannabis, predatory lending, military contracting, oil sands, and thermal coal.
Additionally, whereas the ETF’s previous index capped the largest five constituents at 8% and all other issuers at 5%, the updated index extends the 8% cap to all constituents.
Following the updated index methodology, the ETF is now classified as an Article 8 product under the European Union’s Sustainable Finance Disclosure Regulation (SFDR).
The fund comes with an expense ratio of 0.39%.
A new chapter for AT1s?
According to Paul Syms, Head of EMEA ETF Fixed Income Product Management at Invesco, now may be a good time for investors to take another look at AT1s. Syms notes that the selloff in the first half of 2022 has driven yields across many fixed income asset classes to the highest levels seen in the last decade while fixed income markets appear to have stabilized, mainly due to a gloomier economic outlook.
For the AT1 bond market, yields have more than doubled from 3.1% in September last year to 8.1% today, having peaked at 8.4% in mid-July. Spreads also appear to have stabilized at attractive levels.
Investors should note that the yields of AT1 bonds are not typically driven by the riskiness of the issuer, as with other high-yield bonds, but by a contingency element that triggers a conversion into cash or common equity if the issuer’s capital drops below a pre-set level. AT1s are intended to act as a buffer in extreme conditions and will have a lower credit rating, and in turn higher coupon, than the senior debt issued by the same issuer.
Yet, according to Syms, European banks have greatly improved their resilience over the decade following the Global Financial Crisis, having reduced the size of their balance sheets, improved the quality of assets held, and increased capital held against risk-weighted assets. Banks now have plenty of capital in excess of their CET1 trigger levels and sufficient accumulated retained earnings, minimizing risks around conversion and coupon suspension.
In short, Syms highlights that the AT1 market is functioning as expected, with bonds being called and refinanced even through the recent Covid pandemic and the current Russia/Ukraine crisis.