The pressure is set to build on smaller banks as they resume bond funding programmes en masse after years of gorging on cheap central bank liquidity.
For now, borrowers are willing to pay inflated prices to secure a deal. Even for the most vanilla of trades, smaller names still have to pay a massive illiquidity premium — up to 150bp-200bp in some cases.
With the need for bond market funding likely to step up, smaller firms should not be afraid to think a little differently and use every trick in their funding toolkit to shave down these wildly wide spreads and land the cheapest possible deal. Niche currencies and formats beyond standard senior paper provide alluring alternatives.
Small trips abroad
The bank bond market does not begin and end with euros and dollars — there are almost 180 other currencies that borrowers could take a chance on. Of course, not all of these are viable (it is highly unlikely that any European bank would choose to fund directly in Uzbek som). But there are a handful that could repeatedly offer an attractive alternative avenue of funding.
National champions regularly tap the Swiss franc, Aussie dollar and yen markets, for instance, and their second and third tier brethren should take notice. Not only have these markets offered some competitive arbitrage this year, but they have also provided a key source of investor diversity.
And although setting up foreign currency programmes might be pricey or challenging for smaller banks, they bring immense and long-lasting benefits. Launching a foreign currency programme can require internal sign off, in-depth investor relations work, and in some cases even local regulatory approval — but once the hard work is done, the framework is ready to be deployed when needed.
Foreign currency programmes allow smaller borrowers to tap a drastically different investor base to the one it might usually access in its home market. And having access to a wide and diverse spread of investors should prove useful as bond funding ramps up.
The investor universe for these names is smaller — across markets — compared to larger top tier cousins. As banks resume bond funding, there is a risk that investors could quickly exhaust their lines. Here, having access to an alternative market could provide a vital alternative outlet.
Furthermore, the bar for what passes as a significantly sized deal in niche markets is a lot lower than in core currencies. Although shallower than their larger cousins, the smaller sizes offered by niche currency markets can suit second or third tier borrowers well. For instance, the minimum size for inclusion in the Swiss Bond Index is only Sfr100m (€103m) — a far cry from the €500m plus required in euros.
Cheaper prints at home
Of course, thinking differently does not necessarily equate to venturing abroad. There are options for those unable or unwilling to issue outside of their home market. Smaller borrowers could consider lowering their funding costs or widening their investor base through issuing labelled or asset-backed debt.
Many smaller firms already pair their senior unsecured issuance with green, social or sustainability labels. Although the greenium might not always manifest itself in a tighter spread or lower final yield, there is still a captive audience of investment funds with ESG mandates hungry to snap up a deal.
Alternatively, banks could be well served by venturing higher up the capital stack and issuing secured paper, if they do not need to issue debt for regulatory reasons. The cost savings for all issuers — smaller ones in particular — are huge: on Tuesday, the spread between the iBoxx euro covered bond and bank senior debt indices sat at 85bp.
And with bond market funding needs increasing as banks refinance their maturing central bank liquidity, many borrowers are already preparing to return to the covered and asset-backed securities markets in search of the cheapest possible source of funding.
The Co-operative Bank, for instance, is set to dust off its RMBS and covered bond programmes in the next 12 months. The UK lender has focussed its funding efforts on the far more expensive senior unsecured market since 2021 — just last week it paid 9.5% to land a £200m five year non-call four green senior bond at the holding company level.
Although the Co-op's corporate and strategic development director Gary McDermott told GlobalCapital last week that the programme would not be ready until the third quarter, when it is then funding via secured debt will ultimately be cheaper than issuing reams of senior unsecured paper.
If the asset pool is there, why not dive in?
Like their larger peers, smaller banks are finally weaning themselves off the cheap central liquidity that has kept them going over the last few years: eurozone banks are already repaying their targeted longer-term refinancing operations (TLTRO) holdings, while in the UK repayments for the Term Funding Scheme with additional incentives for SMEs (TFSME) are set to start next year.
Although large chunks of this rollback will come from banks draining down their robust liquidity coverage ratio (LCR) levels, it will still have to be supplemented with increased bond issuance. And as these firms step up their wholesale bond funding, they should look to use every trick in their book to ensure they get the best — or cheapest — possible deal done.