Recent turbulence across bond markets has produced a counterintuitive trend: some of the riskiest and most complex debt instruments are proving to be the steadiest performers. According to rolling 10-day volatility data, Additional Tier 1 (AT1) bonds—subordinated debt issued by banks to satisfy regulatory capital requirements—have exhibited volatility roughly 75% lower than that of investment-grade corporate bonds. In contrast, mainstream fixed-income assets, particularly long-dated government bonds, are under sustained pressure from inflation concerns, fiscal challenges, and an overwhelming wave of corporate debt issuance.

The relative calm in AT1 bonds underscores a significant investor appetite for yield within this asset class. Just two years ago, in 2023, struggling Credit Suisse wrote down $17 billion of AT1 bonds to zero, thrusting the instrument into the global spotlight. At that peak of distress, AT1 volatility was approximately ten times that of investment-grade corporate bonds. Even earlier this year, during the most intense period of geopolitical tension involving Iran, the 10-day rolling volatility of AT1s was still nearly double that of their investment-grade counterparts.

“AT1s have extremely low sensitivity to interest rates and show very little reaction to shifts in the macro backdrop,” said Romain Miginiac, fund manager and head of research at Atlanticomnium SA. He jokingly characterized AT1s as now being a “risk-free asset,” adding: “That might be a bit of an exaggeration, but if you look at the performance over the last 12 months, it really couldn't be more stable.”

There are solid reasons underpinning the stability of AT1 bonds. A survey released this week by ABN Amro Bank NV found that coupon income alone satisfies the total return targets of approximately 80% of the investors polled. Shanawaz Bhimji, the bank's credit strategy head, noted that investors whose return requirements fall below current AT1 yield levels “will continue to maintain significant buying interest.”

With yields on AT1s issued by major global banks remaining elevated—and becoming even more attractive as government bond rates climb—investors are flooding into the market. Since November of last year, the number of fixed-term funds aimed at retail investors and focused on perpetual AT1 securities has nearly doubled. Additionally, flexible allocation funds without investment scope restrictions are actively purchasing AT1s, as portfolio managers search for higher returns amid expensive credit market valuations.

AT1s are classified as high-beta securities, meaning their prices theoretically rise more than the broader bond market during upswings and fall more sharply during downturns, due to their elevated risk and loss-absorption features. This makes their resilience during the recent bond sell-off particularly noteworthy. The high yields offered by AT1s largely explain this anomaly and serve as a crucial foundation for sustained demand. These instruments provide richer coupons to compensate investors for assuming additional risks, including the potential for skipped interest payments, uncertain repayment timelines, and the possibility that AT1 holders could face losses first if a bank fails.

Data indicates that the Bloomberg Global Contingent Convertible (CoCo) Index yields an average of approximately 5.7%, compared with under 5% for investment-grade corporate bond indices and around 3.7% for government bond indices. AT1s fall within the CoCo bond category, which emerged following the global financial crisis. Their primary function is to absorb losses when a bank approaches insolvency, thereby alleviating the financial burden on governments and taxpayers and preventing crises from spreading throughout the financial sector.

However, the investor pursuit of high yields is causing risk to accumulate. The AT1 spread—a key indicator of whether issuers will redeem bonds at the first call date—has narrowed to record lows. Last week, the global CoCo index spread fell below 200 basis points for the first time ever. Miginiac cautioned that investors chasing yield at such minimal spreads are exhibiting “significant complacency.” A recent dollar-denominated AT1 issuance from BNP Paribas set the tightest reset spread ever recorded for that currency. Earlier this summer, several U.S. banks, including Goldman Sachs and Bank of New York Mellon, issued preferred shares—the primary U.S. banking instrument for supplementing AT1 capital—at their narrowest spreads since the financial crisis.

“Market demand for the AT1 asset class remains exceptionally strong,” said Luca Evangelisti, investment manager at Jupiter Asset Management. He believes that purchases from both new investors and seasoned CoCo holders will support future issuance, “as we have seen so far this year, with order books potentially continuing to see multiple times oversubscription.” Nevertheless, he noted that he is becoming “increasingly selective” in his investments due to excessively tight reset spreads and limited discounts on new debt issues.

Meanwhile, Man Group has issued a warning that AT1 investors are entering the space “without proper consideration,” failing to adequately measure the risks they are assuming. However, European banks—the primary suppliers of AT1 bonds—have seen significant improvements in their balance sheets, and investor concerns over the sector's robustness have largely dissipated. Year-to-date, European bank equities have even outperformed the U.S. tech “Magnificent Seven.” This fundamental improvement could help cushion any future market shocks.

“The historical correlation between AT1s and broader risk-off behavior—whether in equities or government bonds—may not reliably guide future performance, especially when the triggering factors have no direct connection to the banking sector,” said Jupiter's Evangelisti.