But a medium-sized Portuguese lender, Banco Comercial Portugues SA, has shown a middle way to keep both investors and regulators onside. It could have the welcome effect of reducing the increased premium to hold extendable financial institution debt.
Bank capital debt is designed specifically to absorb losses when banks get into trouble, either by being written down or converted into equity. The riskiest type is Additional Tier 1 debt — often known as contingent convertibles, or CoCos for short — which are the most subordinated type of bank debt, with the (usually sophisticated) investor on the hook for the full amount. That’s why the yields are much higher than what’s available on plain-vanilla bonds.
This is perpetual debt, without a maturity date, as it’s equity-like capital that supports the entire balance sheet. The sweetener is these have call options usually after five- or 10 years, allowing issuers to redeem early. Tier 2 debt, such as the BCP deal, ranks slightly higher in the capital stack as it has a fixed maturity as well as call options.
However, there is absolutely no guarantee that investors will be repaid early. In good times, these types of bonds are usually the most lucrative bank debt available; but extension risk has exacerbated their yields this year.
European investors typically expect banks to call and refinance these bonds at the earliest opportunity even if it’s uneconomic for the issuer if it requires reissuing similar debt at a higher interest rate. However, this convention is increasingly frowned upon by the European Central Bank, which wants everybody to recognize hybrid debt as permanent equity capital rather than regular debt funding. It requires banks to seek its approval if they trigger call options, to ensure they are not compromising solvency. The regulator wants to avoid systemic risk if refinancing actions increase the risk of bank failure; official bailouts, as seen frequently during the euro crisis a decade ago, have become politically toxic.BCP is following the ECB’s guidance by skipping the December call on its €300 million ($290 million) Tier 2 bond due 2027, but is softening the blow by offering a buyback of this bond into a new deal with a higher coupon and longer maturity. So although bondholders won’t get back full repayment of a bond that is trading in the mid-80s cents to the euro — which they would if BCP triggered the call option — they will likely receive a higher level than the market price. Investors who tender the existing deal are likely to receive full allocations into the upcoming replacement. The key for the regulator is that the same amount of Tier 2 capital is at least maintained, as the original bond remains, although of a smaller size, and the new instrument makes up the shortfall at a manageable extra cost for the bank.
Similar liability management exercises, or buybacks, have been undertaken recently by a UK bank in its AT1 bond, Shawbrook Group PLC, and even by a restructured German lender, Hamburg Commercial Bank AG, in its senior non-preferred debt. Bloomberg News has listed next year’s upcoming calls on AT1 debt. Austrian lender Raiffeisen Bank International is the next European institution with an AT1 call date, in mid-December.
There is no hard-and-fast rule to skipping calls. While investors understand that the prospectus allow issuers to do as they choose, European banks have typically exercised the options to keep investors sweet. The situation is different in the US, where bondholders expect borrowers to follow the most cost-effective route in deciding whether to refinance existing debt.
But due to much higher yields, it is increasingly in the economic interest of European issuers not to refinance. Spanish lender Banco de Sabadell SA chose last month to skip the call on one of its AT1 deals. Nonetheless, Barclays Plc recently called an existing AT1 deal and reissued similar debt at significantly higher cost. Credit Suisse AG also did something similar, though this was part of a bigger restructuring package that also involved debt buybacks. However, these entities are not monitored principally by the ECB, but by the Bank of England and Swiss regulator Finma, respectively.
Every bank’s management deciding whether to forego call options has to balance the impact on future investor appetite with the wishes of the regulator. If the overall effect on the bank’s capital stack is broadly neutral then market overseers ought to be flexible in these turbulent times. Being shut out of the riskier end of the debt market is a fate no institution wishes to endure, as it can dramatically reduce its ability to operate. Over-regulation can be as much of a systemic risk as too light touch. The ECB should bend with the wind where it can, while keeping the overall direction of travel for the European bank capital market to move closer to the US model.
More From Bloomberg Opinion:
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• ECB Drains the Punchbowl for Economy and Banks: Marcus Ashworth
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.
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