Why AT1 Still Matters In 2027

(MENAFN- ING) AT1 reform remains on the back burner

The European Commission published its report on competitiveness in the banking sector in July but did not include much in the way of proposals for AT1 bank capital instruments. The report mainly focused on reducing complexity, reporting requirements and improving competitiveness for Europe's banking sector.

For AT1, this probably means that the instruments are unlikely to be phased out anytime soon. What is somewhat relevant for AT1s is the Commission's intention to reduce complexity for bank capital structures. This includes making the Pillar 2 requirement and guidance more transparent, while the Commission also proposes to consolidate parts of the buffers into two buffers: one that can be released in periods of stress, and another that would be maintained in all scenarios.

This, in theory, could reduce the risk of coupon skips, as being able to release buffers during periods of stress would not automatically lead to a breach of the combined buffer requirements. The proposals also include a removal of the leverage ratio Pillar 2 capital requirement, which would affect the largest European systemically important banks subject to this requirement. This is only a small number of banks but could (in theory) lead to a marginal decline in AT1 issuance.

Overall, AT1 reform remains part of a broader discussion, with the EU Commission proposals also likely to change as negotiations remain ongoing and consensus needs to be built. For AT1, we expect the instruments to keep playing an important role (yay!) in European banks' capital stacks, with no signs of an imminent abolition or grandfathering process.

More supply while refinancing remains the main event

With no major changes to AT1 structures or requirements imminent, we don't expect a significant impact on banks' capital instrument management and funding plans in 2027.

Primary issuance in euro-denominated AT1 and Tier 2 has been in line with expectations in 2026. EUR AT1 issuance has just passed €15bn at the time of writing, slightly above our expectation of €15bn. Similarly, EUR Tier 2 has reached €27bn, nearing our expectation of €30bn for 2026.

In 2027, we expect a modest increase in supply, largely dominated by the refinancing of upcoming redemptions/calls. We expect €20bn in AT1 supply, compared to €14bn of calls. While this represents a step-up, incremental net supply is only around €3bn higher than in 2026. Tier 2 redemptions will also rise by around €3bn next year, supporting our increased supply expectation of €35bn in Tier 2.

While gross supply will be higher, net supply should remain easily absorbable. More supply should create opportunities in primary markets, although lower reset levels have left some recently issued bonds more exposed during weaker markets.

AT1 redemptions pick up next year

(€bn)

Source: IGM, ING

"> French banks: Déjà vu?

French sovereign risk has increased, with the 10-year OAT-Bund spread now trading at around 160bp at the time of writing, the highest level since 2011. The French 10y yield is around 5%, the highest level since 2002. The story in French markets is growing more sinister by the day. But contagion risk across the eurozone is (so far) relatively contained. Italy and Belgium stand out as other higher-risk countries, given high debt levels and deficits, but it remains a French story for now. Nonetheless, the domestic sovereign exposure and the sovereign-bank nexus have come back into play.

So far, the market is not questioning the broader future of the eurozone. Still, France is of a much larger magnitude than countries such as Greece or even Italy, which had to be supported during the eurozone crisis.

What can be said is that French banks, as well as the broader European banking sector, are in much better shape than they were during the eurozone crisis. French banks' capital ratios have increased significantly and now stand at around 13-15% on average, compared to c.9-10% during the eurozone crisis. Liquidity levels are healthy, while earnings and exposures, particularly for the larger banks, are well diversified. For instance, BNP Paribas generated around 25% of its revenues in 2025 in France, while French deposits account for 29% of the total. For Société Générale, France accounts for 40% of exposure.

French banks' direct exposure to OATs is also not that large; it represents around 6% of total assets, while roughly two-thirds is held at amortised cost, making holdings less sensitive to valuation declines. Some French banks do carry higher exposure, particularly those with limited geographic diversification. For instance, La Banque Postale shows the highest OAT exposure as a percentage of CET1, at 114%. But around 95% is held at amortised cost.

On average, for most French banks, OAT holdings represent around 15-30% of CET1. For context, the data suggests that a 100bp widening of the large French banks' domestic sovereign holdings would lower CET1 for BNP and Société Générale by less than 10bp, and up to 25bp for Crédit Agricole.

French banks OAT exposure appears manageable Source: Company reports, EBA, ING

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Still, the risks are rising and sustained high OAT-Bund levels could feed into the real economy, credit demand, confidence and asset quality. While non-performing loans (NPLs) are low for French banks, they have risen a bit in recent quarters, and we could see more procyclical provisioning from French banks, in particular for SMEs and consumer loans.

Risks could also arise from other avenues. Moody's surprisingly maintained France's rating at Aa3, with a negative outlook, despite broad expectations of a downgrade. Nonetheless, rating downgrades remain a risk, and S&P is due for review at the end of November, bringing further sovereign ratings pressure.

A larger move in OATs would also be more disruptive, as higher yields, social unrest and political fragmentation complicate deficit reduction. October's preliminary composite PMI of 48.4 adds to the weaker-growth picture.

However, we do not think this is the same sovereign-bank loop as in 2009-2012. European Central Bank funding facilities, the Bank Recovery and Resolution Directive (BRRD) and stronger liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) requirements have reduced banks' dependence on sovereign guarantees. The link remains: ratings, domestic bond holdings and a shared operating environment still transmit sovereign stress into bank funding costs and market access.

The flip side is that liquidity requirements and favourable EU sovereign risk weights have made banks important buyers of government debt. As ECB purchases ended and TLTROs were repaid, sovereign holdings have partly replaced central bank reserves for LCR purposes. Banks rely less on sovereign guarantees, but on the other hand, sovereigns arguably rely more on banks for funding.

This new relationship, alongside expectations that the ECB would contain broader spillovers, perhaps helps explain why bank spreads have not widened as much as OATs. The ECB's refinancing and bond purchase tools remain part of the toolkit, although they have previously been used in a different inflation and rates environment.

Without sovereign relief, pressure is likely to persist, particularly for domestically focused banks with larger relative OAT holdings. Limited issuance may slow the repricing, but the distinction between issuers remains important, especially in AT1.

French AT1 underperforms

French AT1 has underperformed YTD and now trades wider than most other major country cohorts in EUR AT1. That mostly reflects heightened sovereign-bank nexus concerns and OAT-Bund spread widening, rather than a deterioration in fundamentals. However, it also reflects market concerns about potential ratings impacts and ongoing political and fiscal volatility, as well as a weakening in the macro environment.

We would avoid treating all French banks similarly. Sensitivity to OATs and the French economy differ quite a bit across issuers. As such, the recent widening has been quite uniform, but the market could become more selective in French AT1s if nervousness continues into 2027. We think the most diversified names, including BNP and ACAFP in short-call bonds, with high reset levels, should hold up better.

French AT1 spreads trade at the widest levels in EUR Source: IHS Markit, ING

"> Calling remains the base case, while the economics are changing

Banks have continued to call their AT1s this year, and calls (or tenders) remain our base case for 2027. While the decision to call or extend is highly dependent on market circumstances and, to a lesser extent, driven by regulatory approval, we still see a high bar for not calling/replacing.

AT1 reset levels have hit lows in 2026 Source: IHS Markit, ING

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This is especially the case as the reset levels remain low, while overall coupon levels are in line with recent historical averages. The economics become less comfortable further out. Reset spreads decline for bonds callable from 2030 onwards, leaving these bonds more sensitive to higher rates and deterioration in market access. However, reset levels remain high on average through to 2029 callable bonds.

AT1 coupons have declined, but still remain elevated Source: IHS Markit, ING

"> AT1 and Tier 2: Spread widening at different speeds

The EUR AT1 index has widened by 19bp year-to-date, outperforming callable and bullet Tier 2. Over the last three months, the picture looks different, though. AT1 has underperformed Tier 2 as recent market stress has led to quite a bit of widening. On a beta-adjusted basis, AT1 has had a mixed performance over three months but has outperformed on a YTD basis, suggesting the recent sell-off has reversed the trend a little bit.

AT1 has widened in recent months as volatility has come back to markets Source: IHS Markit, ING

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However, the correction has only moved spreads from tight to merely quite tight. The AT1 index now trades at a similar level to the 2y median of asw+295bp. Callable Tier 2 also trades just inside the 2y median after the recent widening. The AT1-Callable Tier 2 differential is around asw+150bp, while the AT1/Callable Tier 2 ratio is also in line with the 2 year average.

Both remain a bit compressed compared to historical levels, suggesting that on spread alone, Tier 2 currently offers better value. We see somewhat greater widening risk in 2027, as bank fundamentals soften at the margin, while supply rises a bit and entry valuations remain slightly compressed.

This does not make AT1 necessarily rich at all, but the yield angle remains the key driver of why AT1 could continue to perform well. With rates likely to remain elevated, additional yield combined with some spread widening may lead investors to wait for better entry points.

Reset has mattered more than ratings

High reset spread AT1s have generally been more resilient in 2026, with the 700-800bp reset bucket outperforming by quite a bit over the last three months. While this relationship is not fully linear, and many high-reset bonds are issued by higher beta/lower rated issuers, numbers still suggest that reset levels have been an important driver of performance this year. Higher underlying rates reduce the cushion that lower reset AT1 bonds have had, as extension risk concerns have made more of a comeback in recent months.

Higher reset levels also provide greater coupon protection if a bond is extended during a period of market stress. There are a few near-term low-reset bonds callable with reset levels below +380bp. However, extension risk is still low for these: longer-call AT1s from these issuers trade through the respective reset levels, and these banks have historically assessed calls holistically, rather than purely on an economics or bond-by-bond basis.

Higher-rated bonds have underperformed in 2026. IG-rated bonds have not translated into better spread performance: BBB- rated AT1s now trade at similar spread levels as BB+ and BB-rated AT1s following underperformance this year.

Reset levels have been a better guide for performance than credit ratings in 2026 Source: IHS Markit, ING

"> So where does that leave the AT1 market in 2027?

2027 is shaping up to be another interesting year for bank capital. Valuations look a bit compressed, but bank fundamentals remain solid, with banks likely to continue calling their instruments at the first call dates. In terms of supply, we expect the small increase to be absorbable but potentially lead to investors becoming a bit more price sensitive. Furthermore, the lack of imminent AT1 reform should mean the asset class retains an important role in Europe's banking capital stacks for the foreseeable future.

There are risks becoming more visible, not least through sovereign and fiscal concerns, with France the obvious victim at the moment. A softening of fundamentals at the margin and lower reset levels further along the call curve could create more volatility. Spreads have recently seen some widening, yet there is probably greater scope for spreads to stay wider than for further tightening in 2027.

AT1 yields could remain a good driver of demand for investors, cushioning potential spread weakness. On the other hand, the market is likely to differentiate more between structures and issuer profiles, while remaining wary of banks with greater domestic sovereign sensitivity.

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