But a mid-sized Portuguese lender, Banco Comercial Portugues SA, has struck a middle ground to keep both investors and regulators on the side. This could have the welcome effect of reducing the increased premium for holding financial institutions’ rollable debt.
Bank equity debt is specifically designed to absorb losses when banks get into trouble, either by writing them down or converting them to equity. The riskiest type is additional Tier 1 debt — often known as contingent convertibles, or CoCos for short — which is the most junior type of bank debt, where the (usually experienced) investor is on the hook for the full amount. Because of this, yields are much higher than plain vanilla bonds.
This is a perpetual debt with no maturity date because it is equity-like capital that supports the entire balance sheet. The sweetener is that these typically have a call option after five or 10 years, allowing issuers to redeem them early. Tier 2 debt, like the BCP deal, ranks slightly higher in the capital stack because it has a fixed term and purchase options.
However, there is absolutely no guarantee that investors will be redeemed early. In good times, these types of bonds are usually the most lucrative bank debt available; but extension risk has exacerbated their returns this year.
European investors typically expect banks to call and refinance these bonds at the earliest opportunity, even if it is uneconomical for the issuer to request a reissue of similar debt at a higher interest rate. However, this convention is increasingly frowned upon by the European Central Bank, which wants everyone to recognize hybrid debt as permanent equity rather than regular debt financing. Banks must seek its approval when triggering call options to ensure they do not jeopardize solvency. The regulator wants to avoid systemic risks when refinancing measures increase the risk of a bank failure; Official bailouts, like those seen a lot during the euro crisis a decade ago, have become politically toxic. BCP is following the ECB’s guidance by expanding the December call on its 300m Tier 2 bond by offering to buy that bond back into a new deal with a higher coupon and longer maturity. So although bondholders won’t get full redemption on a bond trading in the mid-80s cents to the euro – which they would if BCP exercised the call option – they will likely get a higher than market price. Investors offering the existing deal will likely receive full allotments for the upcoming replacement. Crucial to the regulator is that at least the same amount of Tier 2 capital is preserved, as the original bond remains, albeit to a lesser extent, and the new instrument fills the gap at a manageable overhead for the bank.
Similar liability management or buyback exercises have recently been undertaken by a UK bank in relation to its AT1 bond issue, Shawbrook Group PLC, and even by a restructured German lender, Hamburg Commercial Bank AG, in relation to its senior non-preferred debt. Bloomberg News has listed upcoming calls for AT1 debt next year. Austrian lender Raiffeisen Bank International is the next European institution with an AT1 call date in mid-December.
There is no hard and fast rule about skipping calls. While investors understand that the prospectus allows issuers to do as they please, European banks have typically used the options to keep investors happy. The situation is different in the US, where bondholders expect borrowers to take the most cost-effective route when deciding to refinance existing debt.
Due to significantly higher yields, however, it is increasingly in the economic interests of European issuers not to refinance themselves. Spanish lender Banco de Sabadell SA chose to skip the call on one of its AT1 deals last month. Nonetheless, Barclays Plc recently terminated an existing AT1 deal and reissued similar debt at a significantly higher cost. Credit Suisse AG also did something similar, although it was part of a larger restructuring package that also included debt buybacks. However, these companies are not primarily monitored by the ECB, but by the Bank of England and the Swiss supervisory authority Finma.
Any bank’s management decision not to use call options must balance the impact on future investor appetites with the wishes of regulators. If the overall impact on the bank’s capital is broadly neutral, market supervisors should be flexible in these turbulent times. Being left out of the riskier end of the credit market is a fate no institution would want to endure, as it can dramatically limit their ability to operate. Over-regulation can pose systemic risk, as can too light a touch. The ECB should bend to the wind where it can while maintaining the overall direction for the European bank capital market to converge towards the US model.
More from the Bloomberg Opinion:
• The Credit Suisse foundation begins to crack: Paul J. Davies
• The banking market with guaranteed profits: Marc Rubinstein
• ECB drains economy and banks: Marcus Ashworth
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Markets Strategist at Haitong Securities in London.
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