BANKS' AT1 BONDS: TOO RISKY OR HIDDEN OPPORTUNITIES?

A journey throughout the unusual characteristics which make these securities so mysterious yet compelling

Oct 1, 2025

Matteo Nicoletti

Among the various forms of financing banks can resort to, Additional Tier 1 (AT1) bonds are characterized by quite unusual features. These characteristics are strongly connected to what Additional Tier 1 represents in banks’ capital structure and make their behaviour on capital markets particularly volatile.

Basel III, a framework regarding bank’s capital requirements adequacy which officially came into force in 2013, divides European banks’ capital into three levels: Tier 1, Tier 2 and Tier 3, even if the last Tier is not always easily recognizable. Tier 1 capital is a bank’s core capital and is composed by Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1), which together must account for at least 6% of the total risk-weighted assets held by the bank.

The capital structure is represented in the table shown below: on the left side each level is ordered from top to bottom based on decreasing seniority rank, namely the grade of priority with which holders of these securities are paid back in case of issuer liquidation or bankruptcy. It follows that senior debtholders are repaid first, while equity holders represent the residual claimants. On the right side, instead, Senior, Tier 2 and AT1 debt securities are compared among each other on the basis of some of their features: it is noticeable that AT1 issues appear more complex and intricate with respect to the other types.

Source of data: Lazard Gestion Fréres

AT1 includes instruments such as subordinated CoCo bonds or preferred shares. In particular, AT1 bonds represent high-yield subordinated bonds, although their higher yield is not linked to a worse credit rating of the issuer. In fact, most of the banks issuing them have investment grade ratings. However, as mentioned above, AT1 debt is subordinated compared to Senior and Tier 2 debt, as a consequence it is priced by investors as riskier compared to debt issues of the other levels. AT1 bonds are typically issued by European financial institutions, the vast majority of which are banks, while US institutions tend to issue preferred shares instead.

As seen in the table, AT1 bonds share three main features which distinguish them from the other debt issues:

1. They are contingent convertible bonds (CoCo), namely they convert into equity or get fully written off based on a loss absorbing mechanism, which triggers when CET1 Ratio falls below a pre-determined level. Among their terms, AT1 bonds can have two types of trigger clauses:

· Quantitative trigger, which provides for an automatic writedown if the CET1 Ratio falls below 5.125% or a higher level. As a consequence, the principal of the bond is written down at least in the amount needed to reach the minimum CET1 target level and the value tied to the amount of written down AT1 bonds is automatically transferred to CET1 shareholders.

· Qualitative trigger, contractual clauses which can activate the trigger even if the specified CET1 Ratio is above the minimum target level. These clauses’ rationale is to strengthen the bank’s capital requirements in case the point of non-viability (PONV), a point of severe financial distress, has been reached.

2. They are perpetual, so they have no final maturity but are callable with previous regulatory approval. Usually, they have call dates every 5 years, at which investors expect to bank to call back the bond and replace it with a new issue.

3. Finally, AT1 bonds’ coupon payments are non-cumulative and discretionary, which means that missed payments do not represent an expense for the issuer, neither they constitute a default event.

AT1 bonds are the ones which offer the highest yield within a bank’s capital structure. On the other hand, AT1 bondholders are exposed to a specific risk denominated as extension risk. AT1s are priced by investors considering the first call date as maturity date, however, based on market expectations, issuers might decide not to call them at the first date. To be clearer, in ideal situations, banks would redeem these bonds at the first call date in order to issue new ones at a lower cost of debt. However, in case of worsened macroeconomic conditions or negative market sentiment, financing costs might be heavily affected, translating into higher risk premiums and wider spreads, thus higher yields for banks to issue new debt. As a consequence, issuers might opt for not redeeming the outstanding bonds, leading to holders having to keep them for longer than anticipated. This is exactly what extension risk consists of, which is why investors demand for higher yields to compensate for it.

As already mentioned, extension risk is heavily influenced by negative macroeconomic happenings, affecting market sentiment and, consequently, the percentage of AT1s priced to perpetuity by investors, reflecting their expectations that these bonds will not be called back at the first date. Typically, during negative scenarios, this percentage gets really close to 100%, due to concerns that the new higher funding costs will force issuers to maintain the outstanding ones on the market without redeeming them.

This phenomenon can be witnessed observing the behaviour of the normalized prices of some of the current outstanding AT1 bonds issued by various international banks. Our objective is to find any correlation between negative events and how they are priced by investors with respect to these securities, in order to verify if the market is efficiently estimating the extension risk.

Global AT1 bonds’ returns are captured by the iBoxx USD Contingent Convertible (AT1) Liquid Index, whose performance is subject to replication by the Invesco AT1 Capital Bond UCITS ETF. Taking this ETF into consideration, these are the securities with the greatest weight in its portfolio.

Source of data: Morningstar

Observing their prices’ behaviour, something is easily noticeable: they plummeted during the first days of April due to fears of an impending crisis following Donald Trump's announcement of tariffs, before returning to normal levels as fears subsided.

Source of data and graphical representation: Cbonds

This is indeed emblematic of the general behaviour of AT1 bonds: during the observed time span, extension risk was touching 100% as investors were fearing that issuers could not redeem at the next call date, due to a possible crisis that could have impacted funding costs, banks’ financial stability, etc. It should be noted that not all drawdowns were of the same magnitude: NatWest’s AT1 issue held up well with a maximum drawdown of 1.22%, while Barclays’ reached a negative peak of 5.99%.

The reason for this can be traced back to market inefficiency while estimating the probability of AT1 bonds not being redeemed at the first call date. Extension risk derives from market sentiment, thus, especially in presence of particularly significant events, it can rise to 100%, suggesting that investors have overreacted and the downside risk has actually already been priced in. This represents a very interesting opportunity to capitalise on the market’s tendency to overestimate this risk.

In support of these statements is the fact that historically 95% of AT1 bonds has been called back at the first date. This tendency is based on the so called “bondholder-friendly” approach pursued by most of European banks, which believe will help them reduce financing costs in the long term. Also, these institutions want to avoid potential reputational risks which could hurt their future issues in case of extension of current outstanding bonds.

In summary, AT1 bonds represent high-yielding securities whose volatility is strictly linked to market sentiment and perceived extension risk. Historical data shows that this risk is often overestimated, as most of AT1 issues are called at the first date as scheduled due to banks’ aim to maintain positive relationships with debtholders and lower long-term funding costs. This tendency creates opportunities for investors to capitalize on market overreactions during periods of stress, making AT1 bonds a complex but compelling segment of banks’ capital structure.

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