Tiers for fears

Like schoolchildren rushing to finish their homework, Europe’s banks are in a frenzy to raise Tier 1 capital ahead of the implementation of the latest Basel bank compliance rules.

European banks have enthusiastically been raising Tier 1 capital all year. Around €85bn is the total expected for the whole year, according to UBS and with roughly €50bn raised by the end of the summer holidays the rest of the year was always going to be busy.

The reason for the capital-raising is bank compliance with Basel III. In the aftermath of the debt crisis, strict guidelines were set up by the Basel Committee on Banking Supervision in July 2011 to boost balance sheets. Rather like schoolchildren faced with a Monday morning assignment, the rush has been on.

Certainly, September started with a bang. Almost before bankers had put their bathing suits back in the cupboard to be forgotten for another year, Spain’s largest bank, indeed the eurozone’s largest bank, Banco Santander hit the markets. On September 4, it sold a €1.5bn equity convertible euro Reg S issue with a low trigger of 5.125%. The perpetual non-call seven-year bonds were priced at par to yield 6.25%. It was followed a day later by UniCredit, Italy’s largest bank, which sold a €1bn perpetual non-call seven-year bond offering, again at par, to yield 6.5%.

A good start by any reckoning, but almost before the markets had a chance to draw breath, they were hit by three more deals: HSBC, Credit Agricole and Nordea. HSBC sold a hefty US$5.6bn-equivalent triple-tranche deal denominated in US dollars and euros. The US$3.75bn of US dollar tranches were split into US$1.5bn of 5.625% perpetual non-call five-year notes and US$2.25bn of 6.375% perpetual non-call 10s.

The remainder chased a €1.5bn 5.25% perpetual non-call eight-year tranche. It was almost immediately followed by Credit Agricole with a US$1.25bn perpetual non-call five-year at 6.625%. And the week after that by Sweden’s Nordea with US$1bn of perpetual non-call five-year notes coming at 5.5% and US$500m of perpetual non-call 10s at 6.125%.

Alternative routes

What is significant is that all the names that are mentioned are major and systemic banks. It is also worth looking at currency. At the beginning of the year, with a need to boost their capital adequacy ratios and Tier 1 capital, European banks started to raise the money that they needed in US dollars. In particular they went down the Reg S offshore route. This avoids much of the tiresome documentation issues that issuers have to face when going to the onshore US market – the 144A route.

It appeared a smart move, with heavily oversubscribed deals from Asian and European accounts. In early May, for example, Spain’s largest bank, Banco Santander, priced its debut US dollar Additional Tier 1 bond issue. It was a US$1.5bn perpetual non-call five-year bond offering that attracted more than US$10bn of demand. And UBS saw similar enthusiasm for its US$2.5bn 10-year bullet Tier 2 issue that attracted more than US$7.7bn of orders.

CoCo the summer

Before the summer break, the last European bank to raise AT1 was Deutsche Bank, with a mammoth deal at the end of May. Germany’s most significant bank raised €3.5bn in a three-tranche sale of contingent capital bonds. It sold a US$1.25bn tranche at 6.25%, a €1.75bn tranche at 6% and a £650m tranche at 7.125%. What made the deal stand out – aside from the size of the trade itself – was that the book was more than seven times covered with more than €25bn of orders.

The reason for the attraction of the US market is not hard to divine. Part of the challenge with euro issuance is the low absolute rates in euros. “If you price at mid-swaps plus 350bp that gives a coupon of only 4%, which is seen as too low by some for subordinated risk,” said Barry Donlon, head of capital solutions group EMEA, at UBS.

That is one of the reasons that issuance in euros has tended to avoid the non-call five route, preferring non-call seven or non-call 10 structures.

“While cost in terms of spread and yield is important, actually raising the capital in the currency that the bank needs is crucial”

The investor base for US dollars is generally broader. And when you look at valuations, the spreads are wider in euros, keeping it cheaper for banks to issue in US dollars, while optically offering a higher yield due to the steepness of the yield curve. The more so because at the beginning of September the basis swap moved in favour of European borrowers issuing in dollars and swapping back to euros. Several bank analysts estimate that issuers could save up to 50bp in that market rather than the euro market.

But it is not quite as simple as that. Currency is defined by the issuer’s internal needs.

“While cost in terms of spread and yield is important, actually raising the capital in the currency that the bank needs is crucial,” explained Mark Geller, head of European financial institutions syndicate at Barclays. More to the point, said UBS’s Donlon, “a lot of auditors classify AT1 as equity, so it can’t be hedged”.

This is why euro issuance is 70bp–100bp more expensive. There is also the point that if you only have a euro balance sheet you can’t do dollars.

Perpetual appetite

What is also significant is the perpetual investor appetite for AT1 paper, which has, broadly, been massively oversubscribed for much of the year. There has been little let-up.

The Nordea trade, for example, saw books of US$11bn for its US$1.5bn deal. What has helped is the – broadly – solid performance of the AT1 paper in secondary trading.

While Santander’s bond has been kicked into the secondary market thanks to a perception that the bank had tried to borrow too much money and been too mean with what it wanted to pay (towards the end of September it was trading down at 97) many of the others were trading up. UniCredit was trading above reoffer at 100.375; the euro portion of HSBC’s bond was up a point at 101; and Nordea was up at 101.125.

Proof positive of the demand can be seen in the moves that investors have made to take advantage of the issuance. BlueBay Asset Management, one of Europe’s largest managers of fixed income credit, has recently set up a capital securities fund, and Pimco has seen incredible demand for its own fund. Set up with US$200m in July 2013, as of August 29 the fund had hit US$4.4bn.

But beneath the book sizes and demand is a more interesting story in how the shape of the books has changed; towards real money accounts and away from purely yield-based investors. This is especially important as the participation of pension funds in Basel-compliant trades has been limited thanks to their own capital requirements.

“Hedge funds were predominant players early on. It is transitioning to real money and fund managers,” said Vinod Vasan, global head of FIG origination at Deutsche Bank.

In the Deutsche Bank deal in May, for example, hedge funds took 20% of the sterling portion and getting on for a quarter – 23% – of the US portion. By the time of the Santander trade it had slipped to 15% and for Nordea was even lower.

What may slow down bank debt issuance for the rest of the year is that the ECB is en route with its assessment of the balance sheets of the eurozone’s largest banks, including an asset quality review to see if they are hiding any unpalatable loans. This is before it takes over direct supervision of about 120 banks in early November. The results of this comprehensive assessment, conducted with the European Banking Authority, were expected in the second half of October. Those found wanting will also need to raise more capital.

Test of market rationality

Although there is a great deal of public noise surrounding these tests, few express genuine concerns about the outcome of the stress tests. At most, explained one banker, there will be a middle ground of a couple of banks that will technically fail and “have to pay over the odds for a €300m issue”. It will be, say bankers, a test of market rationality.

The more serious issue is that the window of executing a trade before the end of the year is narrow – five weeks at most. The bonds sales that have been seen to-date have been from the national champions.

At first glance the AT1 structure appears to be a pretty narrowly defined instrument and one where most elements have been settled. But elements such as forms of loss absorption and trigger levels can be adjusted. In the Santander and UniCredit bond issues, for example, the trigger level was set at 5.125%, while for the HSBC it was set at 7% and for Nordea even higher at 8% – the highest for this type of instrument so far. Premiums for other features like callable and dated structures, which at the moment are priced indiscriminately, will also be priced in.

What this means is that execution and structuring of deals might become an issue if too many second tier banks try to push through a deal before the year-end. While the top banks for AT1 issuance – Bank of America Merrill Lynch, Goldman Sachs, Citigroup, UBS and Deutsche Bank – have big enough teams, several bankers speak of the possibility of a car crash at the end of October.

Gloom aside, if the theme of 2014 has been AT1 paper, the theme for 2015 is going to be Tier 2 paper. These bonds absorb losses after Tier 1 assets such as common equity and retained earnings, cannot be guaranteed by the issuer and must be subordinate to depositors and general creditors.

Despite the structural complexity, they remain much sought-after by investors, who have been lining up to buy them. This year they has been especially popular in Asia, where the top five Chinese banks announced plans to sell US$43.5bn of Tier 2 debt before the end of next year.

Tier 2 paper has also performed well in the secondary market.

“If you look at the performance of Basel-compliant paper over the summer, Tier 2 paper is tighter by nearly a point while AT1 bonds are up to 15bp–20bp wider. Indeed, T2 bonds have outperformed senior paper. That says something about the investor perspective and relative value,” said Jonathan Weinberger, head of capital markets engineering at Societe Generale Corporate and Investment Banking.

Lisbon casts a shadow

The reason for the hesitancy of the European issuers so far has been the shadow cast by the failure of Lisbon-based Banco Espirito Santo, once Portugal’s largest bank. In early August, the bank needed a government bailout and the Bank of Portugal came to the rescue, to the tune of €4.9bn. The bank was split up, but while depositors and healthy assets were moved to the newly created Novo Banco, bad loans and junior creditors, including Tier 2 bond holders, were effectively wiped out as they stayed with the old bank.

“The BES incident is not that unhelpful. It has reminded investors that there is a risk to junior debt and Tier 2 instruments. It can be thought of as a wake-up call. On the positive side it should also be noted that it is a real-life example of resolution, and one under a national regime too”

The immediate aftermath was not pretty. The cost of insuring sub-debt widened by 20bp according to the iTraxx Subordinated index and recent Basel-compliant bonds suffered in secondary trading, some recent deals as much as eight points off. But what is notable is how quickly the market sobered up.

“What could have been a systemic incident is actually now considered an incident, an episode, which is restricted to this bank and to the owners of this bank,” said Mario Draghi, president of the European Central Bank, soon afterwards.

“It affected neither the banking sector in Portugal, nor Portugal at large, nor other markets,” he added.

Bankers agree. “The BES incident is not that unhelpful. It has reminded investors that there is a risk to junior debt and Tier 2 instruments. It can be thought of as a wake-up call. On the positive side it should also be noted that it is a real-life example of resolution, and one under a national regime too,” said the head of capital securities at a bank in London.

What this means is that there is going to be little let-up in the stream of Basel-compliant issuance and little slowdown in the demand to buy it.