But a medium-sized Portuguese lender, Banco Comercial Portugues SA, has shown a middle way to win over both investors and regulators. This could have the welcome effect of reducing the increased premium for holding extendible debt from financial institutions.
Bank capital debt is designed specifically to absorb losses when banks run into trouble, either by being written down or by converting it into equity. The riskiest type is additional Tier 1 debt – often known as contingent convertibles, or CoCos for short – which is the most subordinated type of bank debt, with the (usually sophisticated) investor liable for the full amount . This is why the yields are much higher than those available on vanilla bonds.
It is a perpetual debt, with no maturity date, because it is equity-like capital that supports the entire balance sheet. The sweetener is that these have call options typically after five or 10 years, allowing issuers to prepay. Tier 2 debt, such as the BCP deal, ranks slightly higher in the capital stack because 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 returns this year.
European investors generally expect banks to call and refinance these bonds as soon as possible, even if it is not profitable for the issuer if it requires the reissuance of similar debt at an interest rate higher. However, this convention is increasingly frowned upon by the European Central Bank, which wants everyone to recognize hybrid debt as permanent share capital rather than regular debt financing. It requires banks to seek its approval if they trigger call options, to ensure they do not compromise solvency. The regulator wants to avoid systemic risk if the refinancing actions increase the risk of bank failure; official bailouts, as we often saw during the euro crisis a decade ago, have become politically toxic. BCP is following ECB directives by skipping the December call on its €300 million ($290 million) Tier 2 bond due 2027, but softening the blow by offering a buyback of that bond in a new operation with a higher coupon and a longer maturity. So while bondholders won’t get back the full redemption of a bond that trades in the mid-80s against one euro – which they would if the BCP triggered the call option – they will likely receive above the market price. Investors who submit the existing deal are likely to receive full allocations in 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, albeit of a smaller size, and the new instrument fills the gap at a manageable additional 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 redemption date, in mid-December.
There is no hard and fast rule for skipping calls. While investors understand that the prospectus allows issuers to do whatever they want, European banks have generally exercised the options to retain investors. The situation is different in the United States, where bondholders expect borrowers to take the most profitable route in deciding whether or not 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 opted last month to skip appeal on one of its AT1 deals. Nonetheless, Barclays Plc recently called an existing AT1 deal and reissued similar debt at a significantly higher cost. Credit Suisse AG also did something similar, although it was part of a larger restructuring plan that also involved debt buybacks. However, these entities are not supervised primarily by the ECB, but by the Bank of England and the Swiss regulator Finma, respectively.
The management of each bank deciding whether or not to forgo call options must balance the impact on future investor appetite with the wishes of the regulator. While the overall effect on the bank’s capital stack is broadly neutral, market monitors need to be flexible in these turbulent times. Being excluded from the riskier end of the debt market is a fate no institution wishes to endure, as it can significantly reduce its ability to function. Over-regulation can be as much of a systemic risk as too light an approach. The ECB should bend with the wind where it can, while keeping the general direction of travel for the European banking capital market to move closer to the US model.
More from Bloomberg Opinion:
• Credit Suisse Foundation Begins to Crack: Paul J. Davies
• The banking market where profits are guaranteed: Marc Rubinstein
• The ECB empties the punch bowl for the economy and the banks: Marcus Ashworth
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Market Strategist for Haitong Securities in London.
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