🇬🇧 Financial Credit, Explained: Understanding Bank Capital and AT1s

Added: 2026-05-14

[00:00:00]Overall, I think financial credit is a fascinating one because it's a night and day difference today for the sector today versus what it's been in the past.

[00:00:09]Investors sometimes forget this is the only sector in Europe that is stress tested every single year. And there's pretty rigorous standards that are dished out, which means that if you don't comply with the standards, technically, you can't really be in the lending business. And so the banks are just held always to the highest standards. And better than any other time in in in their financial history, they've not been as strong fundamentally as they are today.

[00:00:43]>> [music] >> So, Bruno, Algebris Investments has been investing in global financials for 20 years now. And over this period, the asset class has evolved and matured, and the ways in which it can be accessed have evolved.

[00:01:00]We just thought we'd take the opportunity to ask a few questions of you in your role as senior portfolio manager to revisit the origins of financial credit, how the asset class has matured, and then how Algebris's offering has adapted. So, I'm just going to start with a very basic question, which is, can you explain how banks um are different to other corporates, and what does the capital structure of a bank look like? Yeah, it's um I think it's always good to start from the basics because I think for a lot of people who've never come across financials, you know, it's just not like a normal company. You know, there's no such thing as EBITDA, there's no such thing as enterprise value. People sometimes look at the debt on a bank's balance sheet, and uh they realize it's not the debt that you find within a corporate. I think what's interesting about the banking sector is that ultimately, um the bank's job is simply to intermediate between what is de facto very fickle, short-term deposits, and what is the need by corporates and borrowers, home owners, credit card borrowers to have some sort of funding that is much more stable and long-term.

[00:02:04]And so what banks try to do is they assess the credit rating of what some of these borrowers are going to be. They try to assess what a probability of default could be, what the loss at default could be, and therefore they're required to have some sort of capital backing those potential losses as the loan kind of progresses over time and it get paid down by the borrower. So unlike a corporate which basically just goes to the bank and borrows and pays it's effectively an interest rate and pays back the principal, the bank always has to be evolving and reassessing the risks to these borrowers. And so in order to fulfill those requirements from a regulatory perspective, what you find is that the bank not always is able to fully back a loan with deposits. It has to go into the market. And when it goes into the market to find additional funding, what you find is unlike a corporate that may just have equity and bonds listed, a bank could have up to eight, nine different layers of borrowings that are actually in the market. And they can range from various elements of capital all the way down to different elements of funding. And so as you move down the capital structure, which means you're actually moving closer towards equity, you do enter into what we think is obviously a better, higher risk, higher reward perspective.

[00:03:16]And so what we do at Algebris is basically we take a fundamental bottom-up view on pretty much every global financial issuer that is out there. We reassess at what point of the capital structure we think the risk reward is the most attractive. And once we've done that, we basically commit to that part of the capital structure and across all the different mandates we run, we basically decide to invest.

[00:03:38]Whether it be across AT1s, whether be across tier twos, whether it be across senior preferred, senior non-preferred, covered bonds, it really is a case of tell me what the borrower is, we will do the work, and from there we reassess where in the capital structure we want to be invested.

[00:03:58]Okay, so staying with the basics, can you just explain in a very simple way the structure the capital structure of a bank?

[00:04:05]Yeah, so basically the the bank's first layer of of of loss taking is always its equity structure.

[00:04:11]Um across the equity structure, the next layer that comes in, which is a new layer um that's been around now for about 12 years, is this AT1 layer. And then obviously then we hit the more traditional asset classes that we've had for quite some time, uh tier two capital. Uh we then hit senior, uh which now has been split into a preferred and a non-preferred status. But basically, in essence, um as you become more comfortable with the borrower uh rating, as you become more comfortable with the bank itself and the investment case, you are prepared to move down the capital structure, which is you start looking more towards AT1s, and you start moving away from the seniors. Now, the flip side could also occur. Um this was something uh that happened to Credit Suisse. Obviously, as Credit Suisse started to deteriorate, you actually wanted to move up the capital structure.

[00:04:57]And so obviously, one trade that Algebris was very focal about, um and it almost came 1 year before um the whole event transpired in March of '23, was that Algebris did take the decision to rotate out of Credit Suisse AT1s and move into what we deemed to be the safer part of the capital structure, which was the senior funding of the bank. Which by definition is going to have a lower yield, but you did it purely because it was a safer option in to you know, to be exposed to Credit Suisse paper. No, absolutely. I think I think the element that sometimes gets overlooked a lot by investors when they buy any bond, it's not just a financial bond, is that and it may not occur to you when you do this, is that when you buy any bond, you are writing a put option. And what we mean by this is that if you think of what a bond is, a bond is simply an IOU.

[00:05:44]A bond is basically something that says, I will pay you X percent of interest over Y years and at Y years I will return your principal to you. Now, if you think of what a put option does, a put option does that. When you sell the put option, you de facto are clipping your coupon for selling the put option, but Lord forbid if something does go wrong, you have all the downside. So, whenever you're reassessing where in the capital structure of bank you want to be in, you have to be cognizant that you have sold a put option on that entity.

[00:06:12]And so, when we looked at Credit Suisse and there were a lot of red flags that we deemed there to be in the market, we just thought that it didn't make sense given the differential between the yield of what the AT1 was and what the senior was, we didn't feel we were being sufficiently compensated to be in AT1s over seniors, hence we decided to move up the capital structure and rotated into the senior part of that.

[00:06:36]Can you explain why is financial credit as an asset class interesting compared to other areas of credit markets?

[00:06:44]Well, I mean, in Europe especially, I think what's fascinating about financial credit is the fact that unlike in the US, where a lot of corporates, you know, and even through private credit, they actually can get access to capital markets and funding, in Europe it's still very much driven by the banking sector. It's a very capillary network.

[00:07:01]You know, if you look at how much of credit growth comes from the banking sector that is funded by European banks today, it's probably anywhere from 80 to 90%, which means that, you know, if you want economic growth in Europe and you rely on credit growth, it's got to be the European banking sector. I don't think it's a surprise that when you look at, for example, something like a Vanguard European equity ETF, you've actually realized that their inflows this year alone are up 70% within financial equity and we ourselves have our own fund, we've seen what our flows have done. You know, within Albus itself, since Credit Suisse, our AUM has doubled. And I think that's just a reflection that the market is intrigued by financial credit. The market wants to understand financial credit, and I think the market has realized in Europe, you definitely need the European banking sector if you want to get that economic growth. So, I do think that it's a combination of investors wanting to look for alternatives, probably away from the US. It's investors trying to seek what is now perceived to be a more investment grade asset class, and we're starting to see this come through with ratings, which we can discuss later. Um but overall, I think financial credit is a fascinating one because it's a night and day difference today for the sector today versus what it's been in the past.

[00:08:16]Investors sometimes forget this is the only sector in Europe that is stress tested every single year.

[00:08:23]And there's pretty regular standards that are dished out, which means that if you don't comply with the standards, technically, you can't really be in the lending business. And so, the banks are just held always to the highest standards. And better than any other time in in in their financial history, they've not been as strong fundamentally as they are today.

[00:08:46]You know, we've talked about AT1s, and obviously we invest in AT1s to some extent. Um can you explain why AT1s are more interesting than other parts of the capital stack? Yeah, look, I I think again, it's very much a function of how comfortable you are with the capital structure. And I think what we have to stress here is if we look at what kind of drives Algebris. I mean, there's two things. Algebris in itself, by its name, algebra, simple. Keep it simple. But the second thing is about trust. You know, just like we get entrusted with, you know, investors inflows, we have to be very mindful what we're investing in.

[00:09:21]And so, if we look at the breakdown of the banks and the issuers we have across our funds, they're all national champion banks. So, as the regulation has actually made a lot of these national champion banks safer, it's natural that you progressively move down the capital structure because it's actually safer.

[00:09:38]You actually want to get that extra return that you wouldn't have received before. In terms of yield? In terms of yield or spread, whichever way we want to look at it. But the reality is, for example, you've got two options, you know, right now. You could be sitting, if you wanted to, in a Nestle corporate senior bond that probably pays you 50-60 basis points, or you could be in a UBS senior bond that pays you 100, or you could be in a UBS AT1 that pays you 300.

[00:10:03]So, if you really like UBS and you believe UBS is pretty rigorously regulated and the capital is solid, why would you not want to move down the capital structure of UBS and move away from that safe corporate that exists out there? And so, I think what's happening is, as the market has evolved and as the market is slowly coming to the realization that, you know, one of the consequences of COVID was that the sticky inflation is still around.

[00:10:30]There's very, very few assets out there where your real income, your real yield, is actually above 3%. You know, you've only really got three asset classes to pick from. You can go single B high yield credits, you can go emerging market and sovereigns, or you can buy European bank AT1s.

[00:10:47]You know, and there's still this perception that it's this three-headed beast out there and it's AT1s and I don't like it and something could go horribly wrong. But the reality is that close to probably 65% of the outstanding AT1s now have at least one investment grade rating. So, it's not as if this is something that is still quite daunting.

[00:11:05]I think a lot of investors, especially post Credit Suisse, are realizing it's not as bad as you think. And as a result, as you seek that incremental yield, it really is a once-in-a-lifetime opportunity to lock down these excess spreads, excess yields.

[00:11:23]So, and just picking up on the three-headed beast point, can you talk through, we've done meetings where you've talked about the three ugly heads. So, in terms of I know it's difficult, but a brief history of of AT1s and what the three ugly three ugly heads are.

[00:11:37]>> there. No, absolutely. So, like I think I think what's important to stress, especially for someone that's never crossed financials, is and I kind of alluded it to it before, like a bond in principle is I agree to pay you X interest over Y years and you're getting your principal back. Um what happened was during the global financial crisis, there were some instruments in the market and they realized that there weren't standardizations. The the instruments that existed um had some sort of idiosyncrasies that de facto prevented issuers from stopping a coupon.

[00:12:09]Um it prevented the issuers from extending the bond and it prevented the issuers from bailing in the principal.

[00:12:14]And what happened back then, and this is why it's very different back around 2008-2009 where we are today, is that absolute core capital levels were completely different. Asset quality metrics were very different. Leverage was different. And so, when the regulators came around to we need to find capital quickly and they thought they could use these outstanding instruments at the time, they realized they couldn't. And so, what happened was they decided to give birth to an asset class, the AT1 asset class. And what they basically said is, we're going to make this different. So, unlike a normal bond, we don't have to pay you the interest and by the way, it doesn't accumulate. So, if you don't get it in one year, you cannot claim it back any future years down the line. The second point is, I don't really have to call the instrument. I could leave it outstanding. And the third kind of really bad example is that if something does go pear-shaped, then I actually could just write off your principal. And so, what happened is the AT1 is is is a bond, but nothing like your traditional bond and it's just because it has all these three key different features compared to a normal bond that just made investors at the start quite nervous about them, especially because the metrics of the banking system were much weaker back then when the asset class was launched in 13 compared to where we are today.

[00:13:35]And there's also a muscle memory issue.

[00:13:37]So, when people are looking to perhaps be skeptical, they're thinking, "Right, the three risks are extension risk, principal risk, and loss of coupon."

[00:13:44]That That's That's their skeptical reason to not consider it. But actually, the asset class is much much more mature. It's been through a number of events since inception 2013, which is exactly the point you're making. Well, yeah. And And the thing as well that, you know, I think we can rarely see this.

[00:14:02]Um but, you know, European regulation today compared to other parts of the world, it's actually quite well in advance. Um if we think back to what happened in '23, especially with two incidences in the US, there were a lot of concerns from a muscle memory perspective that we were going to have kind of like a rehash over here on European shores, and they never happened. You're talking, sorry, in terms of the regional banks that had Yeah, we had we There were like a couple of issues with the regional banks. You know, predominantly, there was a carry trade that was done by one bank that led to a lot of losses. That happened in Europe in 2014. It was the Greek banking crisis. You know, we then had a run on one bank as well, and again, that happened in Europe in 2017. It was Banco Popular. And so, every time Europe had one of these incidences that took place, they quickly realized that they had to put measures in to just avoid a repeat situation. And so, where we are today is that the regulatory environment is, you know, arguably to some people, maybe a bit too strict, and we can do with a little bit of of easing. And you know, I've made this analogy several times, which is if you take a glass and you fill it up halfway, um the Americans will say it's half full, and the Europeans will say it's half empty. And the problem that we have is the Americans can easily run on a half-full glass of water, but the Europeans will tell you, "No, no, no, it's half empty.

[00:15:18]Until we get it completely full, you shall not do anything." And I think if you look at something basic like share buybacks, what you found was that European banks took at least 7-8 years to do their first share buyback compared to when the US banks were doing it. And I think that was just the kind of like the psychological scarring of what happened. But where we are today looking forward, it's in a much stronger position, which is why all of a sudden investing further down the capital structure in AT1s is a much more palatable safe for investment than at any other time in the history of the financial cycle in Europe.

[00:15:57]And is there anything you can say to explain how the issues are rated now given that the asset class is much more mature? Yeah. It'd be worth just covering that, I think. Yeah, I mean, look, the the rating methodologies that the different agencies employ, um it's just something that they have their own ways of looking at it. But I think what's important on ratings, and I think this is probably the key takeaway, is that when we went into COVID, we actually had a big downdraft of downgrades that everyone was going to expect. No one really knew what was going to happen on the other side. It was something no one had really seen.

[00:16:33]Governments effectively pressed pause on economic activity, and no one really knew what was going to come out the other side of it. And there were already question marks whether the banks could cope or they couldn't cope. And the reality was within 2 years after COVID, we had fully unwound all the downgrades that took place. Now, the more interesting thing happened after '22, which was from '23 onwards, we've had about 130 upgrades in Europe, and they're all concentrated where? In countries that during the global financial crisis did actually proper reforms. So, Spain, a quarter of the upgrades. Italy, 20% of the upgrades.

[00:17:09]You tag in Ireland, Portugal, Greece, you have another 35.

[00:17:13]France actually has banking downgrades.

[00:17:16]You know, Germany hasn't really seen much come through with the exception of maybe Deutsche Bank. And so I think where we are today is at a situation where a lot that thought that okay, it's going to be peripheral Europe. There's always going to be the weakness. That's where you don't want to be. You know, Algebris has always taken the view of doing the bottom-up fundamental work. We've always had, as you know, overweights in those regions. And we've always been accused of well, yeah, of course you'd be overweight Italy, you're Italian firm.

[00:17:42]We're like, no, it's because we do the fundamental work. These banks, by and large, are a lot better than you actually think. Robust franchises. And so what's transpiring now is that the rating agencies have been left with humble pie. And they've had a raft of upgrades that have come through precisely in the areas that no one expected. And so what's happening is today, um and I mentioned this before, close to 2/3 of all outstanding AT1s have actually got one investment grade rating already, which means again, it's not your high-yield asset class that everyone tends to associate it with being. It's actually pretty much investment grade.

[00:18:21]Can you just explain a little bit about how and when Algebris started in context context of what the first fund was and how it's evolved and matured given how the asset class in general has matured and evolved? Look, um um Algebris, I think when we try to figure out our success and I think some of the key pillars and and notwithstanding, you know, the founders and and the key men that were around that actually put it together, I think when you've been around for 20 years and when you think that it started off as an equity long-short and it actually was put together by people that only really had done financials, whether you may want to think it or not, the global financial crisis that came within a few years would have probably killed off a lot of people. Um but what happened was here, it was just a case of keep climbing. You pick yourself up, you dust yourself off, and you go again. And what happened was they realized there was an amazing opportunity in financial credit. Because whereas equity got completely decimated, financial credit was actually offering you amazing returns across US banks. And so what happened was the creation of the fund was down to actually financial credit is a much better risk-reward investment that probably equity was going to be. And so from there, it actually started taking advantage of it. Then you had the birth of a birth of the AT1 asset class and kind of the rest this is is pretty much history. So the advantage that I think Algebris has over other players out there, I think is twofold. First of all, when we look at our all AUM that we run today, about 85% if I'm not mistaken is actually in the financial sector. So de facto Algebris is a financial specialist. Um and then the second point is it's not only just in credit. You know, what we've realized and you whether you go to you know, Credit Suisse kind of showed it. Um you have to understand the views across the entire capital structure. You know, if equity is not safe, then you need to reassess where in the credit capital structure you want to be. And because pretty much there's a lot of experience here within Algebris of guys who started off doing equity and even today some of the partners, founders are actually equity specialists, it just means we are think are in a much stronger position than a lot of funds to quickly get a sense of where you want to be. And that just gives us the edge that probably other funds don't have because we do marry and we do set equity and credit side by side.

[00:20:49]In terms of where financial credit sits in asset allocation cuz you've talked about high yield, we've talked about IG, can you just explain where you think it sits best in terms of asset allocation?

[00:21:01]Yeah, it's it's it's it's it's a good question and you know, what I'm going to What I'm going to I'm going to basically pull on on some of the investor meetings that we've done over the past 12 months.

[00:21:11]And obviously, you know, we've got offices around around the world. You know, between meetings that I've done in Japan, in the Middle East, um in Europe, in London with you, um even in Miami, I think what we're starting to realize is that investors today that come into credit, they tend to barbell credit investments. And they tend to run for rates. They will basically use duration plays. So, they'll use government bonds, 10-year, 20-year, 30-year because after safe investment. And then what they tend to do is actually for shorter duration, they try to get the carry. And I think a lot of them have been playing in some of these, you know, alternative credit funds, private credit, BDCs, whatever you want to call them. But I think they're slowly starting to realize that they come with a lot of leverage. Where we have a slight difference is that we don't use leverage. Our duration is about 3 years. So, if you think of like a barbell between having the duration rates play and having the private credit levered play, we sit right bang in the middle. We're almost like the fulcrum that balances the swing. And the advantage we have there is, you know, when you have excess spread. You know, and right now today we're running around, you know, 275, 285 basis points for AT1s. And I think we just need to just think about that point because I think a lot of investors will look at that and they'll say, "Well, historically it's been always around here and it's super tight and I think it's time to jump off the bandwagon."

[00:22:42]And what I can say is from the meetings I've done and from the travels, I think investors are slowly starting to come to terms with something that is the whole muscle memory starting to break.

[00:22:55]And I think what's encouraging about this is is if you take just standard typical numbers for the sector, what you find is that that the rates worldwide, they're not negative like they were before when spreads were this tight. Um cost income ratios, which is simply like how much do I have to to to spend to transform 100 of of revenues into my profit, that has improved. If we look at asset quality, that has improved. If we look at retained capital, that has improved. And so what's happened is it's a sector that today has a profitability that in absolute terms has doubled. So the question is, well, if everything fundamentally has improved for the sectors, should spreads still trade where they have traded historically at these points in time? And I think what's happening, and I could be wrong about this, is that some investors are starting to realize, no, it makes no sense. You know, why should I be stopping out of being in a sector at a spread level that in the past has been here, but has been much fundamentally weaker than it is today? Yeah. And I think the incremental investor coming in today that is seeking the real income, that is seeking the real yield, is realizing there's very few offers out there. And when we consider that, and this isn't financial engineering, it's just pure it's pure math, is if you're compounding at 6-7% per year, after 10 years, you've doubled your money.

[00:24:20]>> Yeah. And I think that's why every time we go on the road, we actually find less pushback on the absolute spread level, and we actually find more people willing to invest into the asset class. And I think that's the key difference. And I think also when you consider that high yield is at 250 in terms of spread, and as long as the asset class we're talking about here is wider than that, >> than that? it's worth considering. No, I and I think I think that's the key thing as well. It's not like we're sitting here saying, well, you know, investment grade senior debt is trading at 50, and we're telling you we're at 100, we should trade at 75. No, we're actually starting back of high yield.

[00:24:58]And and that's what for some people I think they're starting to realize it doesn't make sense. And I'm willing to take the bet that this is still something that is safe. It's a household name. It's a national champion. It's super well regulated. And end of the day I can trust it and I can sleep well at night. Brilliant. All right. Well, thanks very much, Brendan. I think the purpose of this was to cover a little bit about the the the history of the asset class, where we've come from, um why Altoris has this specialist expertise, and you summarized very well at the end by highlighting investment opportunities. So, though, thank you very much. Thank you.