Bond linked note extends its underlying universe to AT1 bonds now!


First of all, do you remember how a Bond Linked Note works?

If not, please click to revisit our previous article or locate our educational factsheet on Extramile!

So, what’s new now? What are the key benefits of doing a Bond Linked Note vs. a AT1 Bond?

The Bond Linked Note has become a popular product in the past quarter, primarily with the U.S. Treasury as the underlying asset. Recently, an AT1 Bond has also become an available option as the underlying asset for Bond Linked Note!

Key benefits include:

1) During the product tenor, you receive the yield derived from the Bond Linked Note, which is essentially an FCN without a KO feature.
2) If physical delivery occurs, the AT1 bond yield paid through the Bond Linked Note exceeds the yield of the bond itself.

A reminder of what are AT1s & how they work?

Additional Tier 1 bonds (AT1s) are part of a family of bank capital securities known as contingent convertibles or ‘Cocos’. Convertiblity feature reflects the fact that such bond can be converted from into equity (or written down entirely), and “Contingent” feature means that the conversion only occurs if certain conditions are met, such as the issuing bank’s capital strength falling below a pre-determined trigger level or regulatory requirement.
 

The key features are as follows:

1) The loss absorbing mechanism, which is ‘triggered’ when the issuing bank’s CET1 capital ratio falls below a pre-determined threshold. Typically such trigger is either at 5.125% or 7% CET1, depending on the national regulator. Once this trigger level is hit, the notes are automatically converted into equity or written down in full.

2) Regulators require bank capital to be permanent (i.e. perpetual) in nature, so AT1 bonds have no defined maturity, and instead own issuer callability features. AT1s typically have ‘non-call’ periods of between 5 and 10 years, after which investors generally expect the issuer to call and replace the AT1s with a new issue. If the bonds are not called, the coupon resets to an equivalent rate over the underlying swap rate or government bond.

3) AT1 coupon payments are non-cumulative and discretionary. Missed payments do not build up as an expense for the bank, and non-payment is also not considered a default or credit event.


Why AT1 Bonds Now?

AT1 bonds may be the biggest winners in global credit markets if central banks start cutting interest rates. The securities are seen producing outsized gains when rates fall, because they tend to have wider spreads and higher coupons than other debt. Rates traders are still pricing in several rate cuts by major central banks this year.

The risky bank debt “could outperform all credit peers in 2024,” Bloomberg Intelligence strategists wrote. Global AT1s — also known as contingent convertibles — may have gains of more than 7%, helped by their high initial coupons, less expensive spreads and “higher correlation with credit’s expected yield rally from rate cuts,” they said. “Spreads are supposed to reflect the health of issuers, but this is not the way they have been trading. AT1 performance will be correlated to the direction of rates which paves the way for good performance in the context of cuts”, Jeremie Boudinet, head of investment grade credit portfolio management at La Française Asset Management said.

Product Solution

• Much like the standard Bond Linked Note, if the final fixing price falls below the clean strike price, the bond's physical delivery would occur. However, there remains a slim possibility that the Issuer might NOT go for physical delivery—even when the price is below the strike—based on their financial discretion. In such instances, the client would still be at an advantage.

Indicative Terms

Indicative only, subject to the confirmed level on the trade date

Key Risks

• The product is not principal protected and is subject to market volatility and product issuer risk.
• In the case of physical delivery, the value of bonds received by investors may be lower than their initial investment amount. Investors may experience a total loss of capital in the worst case scenario.

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