Investors in the financial institutions bond market have many reasons to look forward to 2020. They can be hopeful, first and foremost, that the value of their investments will continue to be underpinned by investors’ search for yield in the prevailing environment of low interest rates.
They should also be confident that banks that have issued additional tier one (AT1) and tier two capital bonds will exercise call options on notes that become callable in 2020, as they have always done.
In the AT1 format alone there will be 22 bonds up for call in the three major currencies next year, as the asset class enters an important period for redemptions.
The issuers of these deals mostly appear to have access to the AT1 market for fresh issuance at better price levels than they would be able to get by leaving their bonds outstanding.
But has extension risk really ceased to be relevant for bank capital funds?
Investors seem complacent about how banks may look at their capital securities if market conditions start to turn.
Banco Santander gave investors a shock in March when it decided against calling its €1.5bn 5.481% AT1. It was the first bank to extend the life of an AT1.
The market was quick to dismiss the case as an outlier, and since then all banks have dutifully exercised calls on their outstanding deals. Nordea was even said to have paid up to 55bp extra in the market to replace one of its bonds in March.
But Santander’s extension remains an important challenge to the assumption — always taken for granted — that banks will call AT1s just to do right by their investors. The decision indicated the possibility of a shift in mentality.
It is important for investors to bear this in mind as banks enter a very tough period for profitability, when every extra scrap of cost will matter.
Fitch Ratings is forecasting that European banks will face “significant earnings pressure” due to a weak outlook for GDP growth next year, for example.
And Moody’s has warned that ultra-low interest rates will “further erode weak profitability” in the eurozone banking system.
It is hardly unreasonable to suggest that banks could soon be tempted to scrape some extra profits by cutting debt interest.
This is particularly the case where issuers have given up basis points of cost to replace AT1 bonds in the market — an approach that has sometimes seemed to have more to do with investor relations than with cold, hard analysis of the economics.
Since bank funding costs are at all-time lows in Europe, almost every issuer is expected to refinance AT1 instruments coming up for call in the next year or so.
But when the tide turns and spreads are no longer so favourable, investors may find themselves having to deal with a new way of thinking in the AT1 market.
Banks may simply stop caring about investors’ feelings, preferring to focus as much as possible on their own pockets.