“I’m astonished by the support for this trade among European institutional investors,” was the response of one banker to the distribution of the $1.5bn additional tier one (AT1) transaction from Spain’s BBVA at the start of May, which generated demand of about $10bn from 400 accounts.
Almost two-thirds of the BBVA issue was placed with asset managers, with only 22% sold into Hong Kong and Singapore, which is a far cry from the early 2000s, when Asian private banks provided a bedrock of demand for European bank capital instruments.
Some might suggest, provocatively, that there was nothing remotely surprising about the strength of European institutional demand for BBVA’s AT1 deal. Where else, after all, could investors expect to be offered a coupon of 9% for a national champion in the European banking sector — albeit a champion from troubled Spain?
True, the structure of the BBVA CRD IV-compliant deal was new, and, on the face of it, mightily complex, with four conversion triggers. But in today’s low-yielding environment, it is probable that some of the demand for the BBVA deal came from investors who were prepared to overlook some of the structural detail in exchange for an irresistible coupon. More, however, will have been driven by sophisticated accounts recognising the value of the 420bp buffer between BBVA’s core equity tier one ratio and the highest of the four equity conversion triggers.
While the strength of European institutional demand for the BBVA transaction may have been surprising in its historical context, it built on a trend that has become increasingly visible over the last 12-18 months. As Morgan Stanley comments in its latest Coco Compendium (published six weeks or so before the BBVA transaction), the buyer base for recent transactions has been “somewhat surprising in its breadth and depth”.
Specifically, says the compendium, only 6% of UBS’s $2bn 7.625% Coco went into Asia, and “a full 52%” of Barclays’ $3bn contingent capital notes (CCNs), issued in November, was placed in the US. The Barclays CCNs generated demand of some $17bn from 600 accounts, with 28% taken up in Europe and a modest 16% in Asia.
Asia remains crucial
Several important conclusions can be drawn from the recent distribution of Cocos (loosely defined by Morgan Stanley as anything with an explicit trigger in addition to point of non-viability language). The first, however, is that although the participation of Asian investors may be declining in relative terms, rumours of their wholesale withdrawal from the market are much exaggerated. That much is immediately apparent from the distribution data for a number of recent European bank capital issues.
In the case of Société Générale’s $1.5bn perpetual risk adjusted capital (RAC) tier two in November 2012, for example, Asia accounted for 40% of placement, while Danske sold 58% of its $1bn RAC tier two into Asia last September. Rabobank, meanwhile, placed 66% of its $2bn 8.4% issue in Asia in November 2011, with 64% of the transaction absorbed by Asian private banks.
“It’s a little early to say that Asian private bank demand has withered in any way,” says Ronan McCullough, managing director at Morgan Stanley in Hong Kong. “I certainly wouldn’t downplay the very encouraging way in which the European institutional investor base for this product has expanded. But name recognition is still very important in Asia, and one reason why issuers like BBVA and KBC generated more demand in Europe than in Asia is that they are not household names among Asian retail investors.”
McCullough adds: “More generally, Asian demand remains strong. For example, the Asian bid for the Emirates NBD perpetual tier one at the end of May was exceptionally healthy.”
The $1bn Emirates issue was unfortunately timed to coincide with heightened concerns about QE in the US and the mini-meltdown in the Japanese equity market. Nevertheless, it built an order book of $4.25bn.
McCullough says that robust Asian demand for European bank capital first came to prominence in the early 2000s. In particular, he points to Standard Chartered’s $1bn perpetual non-call five tier one issue in 2001, which was priced at a coupon of 8.9%, as a notable landmark in the evolution of demand for subordinated debt into Asia.
“The Standard Chartered transaction was a huge success, underpinned by its tremendous name recognition in Asia,” says McCullough. “That deal was followed by others from a number of borrowers such as BNP Paribas, Lloyds, RBS, Axa and Allianz, all of which were sold predominantly to Asian private banks.”
This demand, says McCullough, was driven by a combination of powerful name recognition and alluring yields. “The higher interest rate environment and the relatively wide spreads on these new-fangled subordinated instruments meant that the absolute yield on offer was sufficiently attractive to the Asian private bank investor base,” says McCullough. At the time, he says, many Asian retail investors were licking their wounds after the bursting of the dotcom bubble and were looking to recycle funds out of equities into fixed income.
Today, yields continue to be as important to the Asian buyer base. “One of the underlying realities of the Asian market for European subordinated bank capital is that it remains dominated by private banks and is still very yield-driven,” says McCullough. “We are seeing more institutional demand. But the distribution power of private banks in Asia, the scale of their assets under management and the fact that many retail investors increase their leverage by buying on margin, means the private banking investor community will remain bigger than the hedge fund or real money investor base for this asset class.”
That means that demand and pricing dynamics in Asia are different from those in the European institutional market. For one thing, says McCullough, the Asian bid tends to be determined more by absolute yield than Libor spreads or relative value analysis. For another, Asian demand can also be more momentum-driven than it is in Europe. “This means that demand can be less price sensitive than in Europe where some institutional orders may fall away at a certain pricing point,” he says.
McCullough emphasises, however, that it is wholly inaccurate to stereotype Asian private bank support as unsophisticated money. As he says, the client base of Asian private banks is a wide spectrum that can range from individuals with $500,000 to invest in a limited portfolio of bonds, through to accounts capable of booking orders in single bond issues of as much as $100m.
The majority of the demand from private banks, says McCullough, comes from investors who are increasingly asking the right questions about complex instruments. “What has fallen by the wayside is the idea that Asian investors will buy bank capital on the basis of the name and the bank’s rating alone,” he says. “Investors are asking about the difference between statutory and contractual triggers, point of non-viability and temporary versus permanent write-downs.”
US comes onstream
Bankers say that US retail investors, which are another important component of the global investor base for European bank capital, are also channelling more resources into analysing the structures of Cocos and Coco-like instruments. “The US investor base has long played an important role in buying capital instruments from large European financial institutions,” says Kevin Ryan, managing director at Morgan Stanley in New York.
Much of the recent demand from US retail has been yield-driven, with European bank capital looking increasingly attractive relative to US bank perpetuals, many of which, says Ryan, have been priced at coupons of 5.5% and below.
“In the domestic market, spreads have come in dramatically in both senior and subordinated debt as US banks have become better capitalised,” says Nathan Wallentin, executive director of the Global Wealth Management Group at Morgan Stanley in New York. “But although there is no longer much in the way of a spread differential between US and European banks in the senior debt market, the spread differential between subordinated securities, including Cocos, now stands out like a sore thumb.”
The reasons for this differential, twinned with the sometimes mystifying evolution of the European regulatory framework, are variables that the US investor base believes are worth dedicating time and resources to understanding. “As an investment banker based in New York each morning I wake up to four or five emails that have come in overnight advising of some new regulatory announcement in Europe,” says Ryan. As long as there were no more than two or three deals coming out of Europe each year, he adds, it scarcely seemed worthwhile for investors to try to keep on top of the European regulatory agenda. “At least there are enough deals now to make the credit work worthwhile,” says Ryan.
Beyond retail participation, evidence is emerging to suggest that the US institutional investor base is becoming more comfortable with Coco-style products. “The second UBS low-trigger permanent write-down Coco, which came in August 2012, was a significant milestone for US institutional involvement in the market,” says Alex Menounos, managing director and head of European IG debt syndicate at Morgan Stanley in London. “That was the first Coco specifically anchored with US institutional investors. Barclays subsequently placed more than half of its high-trigger write-off Coco in the US, confirming demand for both low and high trigger structures.” August’s 10 year bullet Coco from UBS attracted an order book of close to $9bn from about 400 accounts, with 58% placed in the US, Switzerland taking 18%, the UK, 12%, and Asia just 6%.
To date, participation by US insurance companies has been minimal. In the second UBS $2bn issue last year, for example, only 4% of the notes went to insurance companies, with managed funds buying almost half the issue. Granted, insurers played a bigger role in the CCNs issued by Barclays last November, accounting for 11%. Nevertheless, their overall participation remains low, which contrasts with their decisive influence in the market for private placements by overseas borrowers in the US market, where insurers have historically been happy to use their credit skills to identify value, especially at the long end of the maturity spectrum.
The role played by US insurance companies in the market for European subordinated debt may change if and when they are able to pigeonhole bank capital securities with conversion features more effectively than they can today. “Smaller insurance companies in particular are still trying to deconstruct instruments such as Cocos to determine whether they should be booked as preferred, as equity or as debt,” says Ryan. “When we have greater clarity from the NAIC [National Association of Insurance Commissioners] on this, insurance companies may be an investor base to watch because more will want to participate in the market.”
Bankers say that European issuers are of course eager to cultivate a deeper and broader domestic institutional investor base, not least to demonstrate to regulators and rating agencies that there is a diversified reservoir of demand for contingent capital throughout the cycle.
But that does not mean cutting off international retail demand, which bankers say is a deep and sophisticated investor base. As Menounos says, high and ultra-high net worth investors, often with significant investment resources, represent an important source of established and sophisticated demand for deeply subordinated hybrid capital.
Europe catching up
The retail or HNW investor base also offers the appeal of being free from many of the constraints that may have held back the European institutional bid until recently. Foremost among these are the often asphyxiating mandates that dictate asset allocation decisions across large sections of the institutional community. Most of these mandates cling to the notion that debt is debt and equity is equity and never the twain shall meet, which makes it impossible for many institutions to accommodate structures with equity conversion features. “Placing these new generation instruments into traditional fixed income mandates has been a key challenge for many real money investors,” says Menounos.
There are other complications for institutions attracted by the structure and yield of Cocos. The first is that these instruments are generally rated non-investment grade, with their transition from gone concern to going concern products having prompted a fall in their credit ratings.
Sub-investment grade ratings will continue to present a challenge for institutional investors in Europe. Most obviously, punitive capital charges under Solvency II will make the asset class a no-go area for insurance companies.
A second, related complication is the ineligibility of Cocos and AT1 instruments for mainstream indices, which again may be a reason for many institutional investors to give them a wide berth.
Despite these constraints, Menounos says that there are a number of encouraging signals to suggest that European institutions are finding ways around them. “Several of the recent Reg S US dollar Coco and AT1 transactions have achieved two-thirds placement in Europe, predominantly with institutional investors,” he says. “The enduring low-yield environment has acted as a catalyst in the evolution of the real money investor attitude towards going concern loss-absorbing instruments.”
Menounos adds: “Some concerns around structural subordination remain. But the relative yield on offer versus other asset classes seems to have compelled many to assign significant investment resources to this developing asset class. While initially we saw the development of a niche investor base driven by dedicated Coco and hybrid funds, many institutional investors have now adapted mainstream and flagship funds to cope with features like loss-absorption, the point of non-viability and equity conversion.”
Menounos says that while some mainstream European institutions have been relying on off-benchmark allocations to accommodate these new generation and sub-investment grade-rated bank capital instruments, high yield funds have also been pivotal players, accounting for more than half of the internal allocation for some investors. These funds’ antennae will have been aroused by Cocos and AT1 instruments offering high-single digit (and in some cases double digit) coupons.
“Pre-crisis, tier one was typically single-A rated and most deals would clear between 50bp and 100bp over swaps, levels which would not have attracted the attention of high yield investors,” says Menounos. “Now that deeply subordinated transactions are notched further away from senior debt ratings, which in turn are also lower, much of the Coco and AT1 deal universe would be rated double-B, with a yield to compensate — and hence much more appealing to high yield funds.”
Many of these funds will also have taken note of the spellbinding performance of some of the funds that were set up specifically to invest in Cocos. One of the most striking of these has been the Algebris Financials Coco Fund, which was set up in March 2011 and returned 56.4% in 2012 — making it the fourth best performing hedge fund in a Bloomberg ranking of funds with assets under management of $100m or more.
Euro Cocos a matter of time
Nevertheless, a euro or sterling denominated new generation Coco or AT1 transaction remains conspicuous by its absence, with issuers like UBS and Barclays having strategically prioritised US dollar investors with their recent Cocos. Menounos, however, believes that a new generation Coco or AT1 denominated in euros or sterling is only a matter of time. “I believe Reg S dollars was the most appropriate market for BBVA to launch the first AT1,” he says. “But I also believe that the euro market would already support an AT1 transaction in euros for many of the national champions across Europe. Beyond the perception that dollars may currently offer a broader and deeper market, most European institutional investors are either indifferent between the core currencies or have a mandate-driven preference for euros.”
That may be. But analysts are doubtful that there will be a dramatic increase in supply in the immediate future, which is one reason why there is likely to be continued downward pressure on yields. Indeed, in its compendium published in March, Morgan Stanley draws attention to “the (in our view, valid) expectation that there is not a deluge of Coco issuance in the pipeline.”
This view is strengthened by the general belief that the potential universe of issuers remains restricted to national champions. As Menounos says, to date institutional investors in Cocos, in particular for write-off structures, have drawn comfort from the belief that a breach of the trigger is a remote tail event.
This suggests that expectations of an asset class worth $1tr by 2018 — which has been predicted by Davide Serra, CEO and founder of Algebris — may still be premature. Perhaps more important, in the absence of a deep and highly diversified range of instruments in Europe, is that the scope for relative value analysis of Cocos remains limited. As one participant puts it in the investor roundtable discussion in this report, for the time being the market is still pricing liquidity, rather than credit risk.
That, say investors, means that pricing Cocos remains more of an art than a science, although a number of reference points are available to those looking to unlock relative value. “Many investors use a building block approach to pricing, where relative value is expressed as a premium to the host instrument pricing,” says Menounos. “For most investors, valuation starts with an analysis of the buffer to trigger in the context of the magnitude and rate of potential losses in stress scenarios. A bank’s perceived ability to raise fresh capital if under stress, either in the market, through disposals or other strategies is another key variable. Consideration is also given to specific jurisdictions and the likelihood of local regulators stepping ahead
of a trigger event.”