Coco bonds have never been as cheap (or yields as high) compared to equity

^{* Earnings per share (estimates for the next 12 months; MSCI Europe Banks) divided by share price
** difference between equity yield and CoCo bonds YTM}

^{Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 3/22/23}

Nevertheless, pessimistic investors will take away from this episode that laws can be applied flexibly in case of emergency. And bond investors are by profession pessimistic in that they tend to be risk-averse. Therefore, we expect refinancing via AT1s to become more expensive for banks, though not at the current particularly expensive level, which still reflects the immediate Swiss shock. This is shown in our Chart of the Week by the record low difference between the yield on CoCo bonds (which constitute the majority of AT1 capital) and the earnings yield on bank shares.

But a reassessment of the segment seemed overdue anyway. When AT1 bonds were introduced as an additional way for failing banks to absorb losses to save taxpayers' money, Europe's banks held a common equity tier one capital (CET 1) of 5-6%. Today it is almost double that. We do not expect that conversion into equity capital in the sense of the regulations – if the CET 1 ratio falls below 5.125% – will ever happen. The regulator would probably take action before that.

Irrespective of this, the recent events are likely to make every bank keen to strengthen its capital base to avoid coming under the markets’ scrutiny. More reassuringly, the European banking sector is not doing so badly, not only by comparison with 2007-08, but also in comparison with the U.S. now^[1]. This, combined with the market turmoil of recent days, has led us to overweight investment grade euro bonds – even though we assume that the market might remain volatile.