Working in financial markets can resemble being on a fairground ride. One moment you are sitting comfortably, the next you are spiralling and swerving unpredictably.
That’s certainly how things have gone in 2018. After more than a year of serene conditions, financial institutions ran into severe turbulence in the first quarter, as primary markets took a turn for the worse.
The bumpier ride has been changing a number of assumptions for European banks, and has made it trickier for them to plan their capital issuances.
“You didn’t have to be that precise on timing when doing deals in 2016 or 2017 because every spread around the globe was tightening,” says Scott Ashby, co-head of FICM Americas at Morgan Stanley in New York.
“Now it’s about picking the right day and the right market and being adept at navigating headlines.”
Observers were shocked to see the extent of the pressure on the dollar market, which has offered a reliable and deep pocket of demand for European banks in recent years.
Concerns about inflation became a toxic mix when combined with the revelation that US tech and pharmaceutical companies would look to repatriate cash to benefit from incoming changes to domestic tax rules.
Suddenly, people feared that a hefty portion of the buyer base for short end dollar debt was no longer going to be there.
“For the last couple of years, folks have gotten used to the idea that dollars are always going to be available at very attractive levels,” says Ashby. “The volatility we saw in the first quarter was a reminder that issuers have to remain flexible.”
In dollars and euros, investors have been demanding higher premiums for new issues ever since, conscious of the risk that sudden market movements could see them suffering losses within hours of executing an order for a trade.
In January, European banks had been able to price new capital instruments at levels that were flat to — and in some cases even through — the fair values implied by where their outstanding bonds had been trading.
By the end of March, the average concession paid on new capital trades had risen to 25bp.
“You need a period of stability for investors to get comfortable about participating in new issues,” says Howard Brocklehurst, head of Nordic and Netherlands FIG DCM coverage at Morgan Stanley in London. “That was the issue that we had at the end of March. It was not about the levels themselves, it was about the widening trend.”
All grown up
Indeed, the forecast is still positive for bank capital valuations in the long term, particularly in the additional tier one market.
A majority of banks in Europe are coming close to having filled their regulatory buckets in the asset class, for an equivalent of 1.5% of their risk-weighted assets.
“Banks will kind of get there with their requirements next year, so AT1 supply is going to dry up,” says Sebastiano Pirro, a financial credit portfolio manager at Algebris Investments in London. “Even if conditions deteriorate, I think spreads are likely to move tighter once the supply and demand balances out.”
It helps that AT1 has showed signs of having moved more into the mainstream in recent years.
The product has come a long way since its genesis in 2013, when there were serious questions raised about whether there would be enough appetite for the €300bn of supply that analysts had been expecting.
“If you look back through the cycle, the investors in different parts of the capital structure have changed,” says Niamh Staunton, head of UK, Ireland, German and Austrian FIG DCM at Morgan Stanley in London. “Real money has slowly become more comfortable in stepping further down the capital structure.”
A survey of 185 buy-side market participants published by Morgan Stanley in May revealed that just 3% of AT1s were owned by hedge funds, with asset managers (42%) and CoCo funds (35%) taking the bulk.
The survey also showed that investors had a further €149bn of funds left available to buy AT1, suggesting that European banks are still far from testing the limits of demand in the asset class.
“The investor base for AT1s is broad and deep,” says Jackie Ineke, head of European financials credit research at Morgan Stanley in Zurich. “The hedge funds largely got flushed out during the market volatility in February 2016, and their ownership of the market shrunk significantly again last year.”
Ashby says that the US investor base could also have a big role to play in this context.
Preferred shares are sold by US banks to have a similar role to AT1 within the capital structure, but new issuance is beginning to dwindle, diminishing the number of ways in which dollar investors can pick up yield from the financial sector.
“The more AT1 product we see in the US, the more buyers will look at it,” Ashby says. “It trades more cheaply than the US preferred market and if you’re comfortable with the bank that is issuing, then going down the capital structure will make a lot of sense.
“We have been excited to see the size of the AT1 market expand as much as it has in dollars.”
To call or not to call?
But nobody is ready to shrug off the severe volatility that has been impacting financial markets in 2018.
These hazards have been flashed up at a sensitive time for European banks, as they begin thinking in closer detail about how to manage their outstanding stock of regulatory capital over the coming years.
With a majority of banks closing in on having their preferred running volumes for AT1, the focus is turning towards whether they will replace their existing deals as they arrive at their first call dates.
Whereas issuers would exercise calls as a way of doing good by their investors for previous iterations of tier one capital, AT1s have been structured in such a way as to preserve the possibility that they might be kept on the balance sheet as perpetual capital.
After passing the first call date, the bonds reset to paying investors a fixed spread over the prevailing swap rate — a spread derived from the difference between the coupon level and the swap rate at issuance.
“The debate is a lot easier when you are refinancing calls at a better spread than when you issued,” says Brocklehurst. “But the economic argument of calling becomes more challenging when spreads are significantly wider than the resets on existing instruments.”
Even the most pessimistic forecasters for spread levels over the next 12 months think it is unlikely that call decisions for the first wave of AT1s will require too much thought.
In May, BBVA became the first issuer to retire a CRD IV compliant deal, in a decision that the bank has described as a “no-brainer”.
The $1.5bn deal had a 9% coupon and a reset spread of 826bp, which meant that it compared unfavourably with the cost of its $1bn 6.125% deal, sold at the end of 2017.
“Most AT1s that have been issued have coupons that are at least 80% spread,” says Algebris’ Pirro. “Because rates have moved higher, extending them would cause the coupon to step up. And even where the back-end spread dynamics are not clear, we are not going to have cases where the coupon level plummets.”
“The problem comes when the really low back end bonds do not get called.”
These fears are already having a profound impact on pricing dynamics for deals in the primary and secondary market.
Some investors gulped at the start of the year, when Belfius Bank and UBS were each able to price new AT1s with very low reset spreads of below 300bp. Both of the deals had traded down by about 15 cash points by the mid-point of 2018.
“The latest and ongoing debate around pricing is focused on AT1 extension risk, in particular following a number of transactions at the start of the year that were able to push the envelope on pricing, and which have subsequently exhibited clear signs of convexity in a weaker trading environment,” says Alex Menounos, head of EMEA IG debt syndicate and co-head of EMEA FIG FICM at Morgan Stanley in London.
Counting the costs
Part of the concern for investors is that there is simply very little evidence to help them predict how issuers might look at call decisions.
James MacDonald, financials analyst at BlueBay Asset Management in London, wonders whether banks with multiple AT1s will consider the economic cost of refinancing one deal by looking at the blended cost of all of their reset spreads, or whether they will simply focus on each individual instrument.
“If banks look at these decisions on an instrument-by-instrument basis then it could raise the question as to whether they will effectively put a floor on where their bonds trade,” he says. “If an issuer leaves an AT1 outstanding at 500bp over swaps, for example, are they setting a floor of where investors should consider buying them?”
The European Banking Authority has yet to provide further guidance about what the EU’s Capital Requirements Regulation (CRR) means when it says that banks should only replace own funds at terms that are “sustainable for the income capacity of the institution”.
So market participants are relying on piecemeal information about how conversations about calls might play out with the regulator.
Staunton says that these refinancing decisions are unlikely to come down to just a straightforward cost analysis. “There are other considerations that come into play,” she says. “Even if it is more expensive to call and reissue, many issuers will still choose to do so and will have the means to do so.”
For one thing, banks are not quite ready to believe that there will be no stigma attached to being the first to leave a CRD IV-compliant AT1 outstanding past its first call date.
When Banco Popular showed investors what it looks like when an AT1 is wiped out, or when the German lender Bremer Landesbank became the first institution to skip an AT1 coupon, neither issuer was going to need to make a swift return to the market for more capital.
And the muted reaction to decisions from a number of banks to leave legacy tier one instruments outstanding may not offer the clearest indication of how investors would react to a similar decision being made for a new-look AT1.
Matthieu Loriferne, executive vice president and credit analyst at Pimco in London, for example, says that when issuers try to use their call options as aggressively as possible, “it is likely that this will be reflected in their ability to issue hybrids, both in terms of access and in terms of price”.
“We are a bit careful about how we treat AT1 call decisions because it can have a broader market impact,” adds Michael Tromp, senior capital issuance specialist at ABN Amro in Amsterdam.
Tromp notes that these decisions are not only relevant for the AT1 market, because banks embed call options into a range of fixed income products.
“Besides callable tier two instruments, at some point banks might also be able to issue callable non-preferred senior notes, which is something would envisage doing,” he says.
Tend and extend?
So far, banks have appeared keen to move very quickly to nail down opportunities to refinance their AT1s as economically as possible.
Nobody wants to be beholden to replacing a deal against the particular backdrop around its first call date when they may have a chance of locking in better terms by going to the market earlier — especially with funding conditions having deteriorated this year.
KBC is a case in point. In April, the Belgian issuer sold €1bn of AT1 notes to partially refinance its €1.4bn 5.625% instrument nearly a full year ahead of its call date.
“It feels reasonable to build in at least six to nine months of headroom between the moment you think about issuing AT1 and the call date for the bond you’re refinancing,” says Charles-Antoine Dozin, head of capital structuring at Morgan Stanley in London.
“You have to be able to accommodate the time you’ll need to have a dialogue with the regulator and gain permission to call, which can take up to three months. And on top of that, you should give yourself enough time to prepare the new issue and room to navigate market conditions, because you can never be sure that you’ll be able to issue when you intend to.”
But there is a price to pay for planning ahead. Costs will add up while running with a higher buffer of AT1 in advance of a call date, given that the format is the most expensive type of debt capital available to banks.
Dozin says that recent developments in the field of liability management may therefore prove to be hugely beneficial for issuers.
When Austria’s Bawag completed a tender offer for a €300m tier two in June, the exercise seemed to show that the European Central Bank’s Single Supervisory Mechanism was softening its attitudes towards what banks can and cannot do with their outstanding stock of regulatory capital.
Under CRD IV, financial institutions are strictly prohibited from calling, redeeming or repurchasing capital instruments before they reach their fifth year anniversaries.
Though Bawag still had four months to go before its 10 year bullet hit the five year mark, the SSM appeared to appreciate that the bank had already bolstered its capital stock with the sale of an AT1 in April.
“That is the core of what seems to be changing,” says Dozin. “Every time a bank does a new issue well in advance of a call, the issuer could give investors the opportunity to tender for their bonds and switch from the off-the-run instrument into the new one. They would be extending the maturity of their AT1 or tier two bucket while avoiding the cost of carry.”
Going forwards, these new supervisory permissions may even be codified in bank capital regulation.
The European Council has proposed a revised CRD IV text this year that would give issuers greater leeway to redeem their capital instruments before the five year period is up, so long as the issuer exceeds its requirements or replaces the debt with something of “equal or higher quality”.
Going through changes
This could be important for helping banks to navigate the capital markets, particularly if the fragile conditions that have characterised most of 2018 persist much longer.
Windows for issuance appear to be getting narrower and more competitive, forcing banks to think more creatively about the ways in which they approach new deals.
Brocklehurst says that he is nervous about what could happen in the coming months.
“We are in a late cycle environment, execution risk is certainly higher, large scale corporate M&A deals are getting a lot more headlines than they used to and they need a clear runway to come to the market,” he says.
“Add to that the corporate bond market dynamic as the European Central Bank winds down its purchase programme and you are creating the conditions for markets to become more challenging.”
The good news for Europe’s biggest banks is that they have done most of the heavy lifting in terms of capital raising. But they start the complicated job of managing that capital stack at what looks at a very delicate time for financial markets.
With populist politics rising in Italy and other parts of Europe, the UK preparing for its withdrawal from the EU, and US president Donald Trump putting in a daily showing on Twitter, it is hardly likely that investors will find the time to relax any time soon.
“We have not experienced much volatility in recent years, so it has been relatively easy to issue capital,” says ABN Amro’s Tromp. “I would say that is clearly changing.”
| Bank capital: size doesn’t matter | ||
| Following the introduction of the EU’s capital requirements regulation (CRD IV) in 2014, the modern market for bank capital has been dominated by large trades, as Europe’s biggest banks have got on with building up their AT1 and tier two buffers. But that has begun to change more recently, as a number of issuers — particularly smaller financial institutions — have been accessing the market in sizes that are well below the traditional €500m benchmark. Vittorio Monge, head of FIG DCM for Italy, Greece and CEEMEA at Morgan Stanley in London, says that a new benchmark has emerged within this corner of the market. “That is the €300m size context. The line between the benchmark and sub-benchmark world is becoming more blurred,” he says. “More and more issuers are pushing the boundaries down ever further and are keen on looking at new issue exercises in the €100m-€200m range.” Last year banks sold €3.5bn of subordinated debt through 18 deals of between €100m-€300m in size — equal to about 10% of the overall market. This was triple the amount sold in 2016, when sub-benchmark issuance made up for just 3% of the total figures. There are clear reasons why banks are seeking to find a market for capital instruments in sub-benchmark sizes. Smaller institutions may wish to optimise their capital structures by selling AT1 or tier two, which are likely to be cheaper than common equity, but these banks may not require — or even be able to issue — a deal of €500m or more. The approach also allows larger banks to spread their capital issuances out over a longer timeframe, which can help when it comes to minimising running costs. But the sub-benchmark sector has only really opened up in recent years, as investors have become more comfortable with the idea of moving away from the safety of large and liquid benchmarks. A number of funds have been putting greater flexibility into their investment mandates, allowing them to lower their minimum size thresholds and look at buying unrated paper.  “We still have some way to go in establishing breadth in this market but we are seeing investors increasingly develop their frame of thinking around core investments and strategies that seek to capture illiquidity premia,” says Alex Menounos, head of EMEA IG debt syndicate and co-head of EMEA FIG FICM at Morgan Stanley in London. As markets become more volatile, there are some doubts as to whether this investor base will stick around. Sub-benchmark sales have eased off in 2018, albeit alongside a more general drop in the volume of risky transactions. But James MacDonald, financials analyst at BlueBay Asset Management in London, says a turn in market conditions will not in and of itself quash sales of small subordinated bonds. “It is a matter of seeing the right institution at the right price,” he says. “You just have to be paid for the risk of illiquidity.’ Investment banks also have a role to play in keeping the market open, according to Monge. “It is absolutely critical that we can demonstrate to the issuer and to investors that, as a bank, we stand ready to support these deals throughout their life-cycles, including in the secondary market,” he says. |
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