Risk of regulatory par calls rises as AT1 market booms

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Lloyds’ liability management exercise (LME) highlights the potential risks to investors of early calls.

The impact of CRD IV combined buffer requirements, due to be phased in over a four-year period from 2016, is already clear to see in the bank capital market.

Thirteen AT1 deals came to the market between March 11 and April 15, more than doubling total outstandings in this market in just one month.

As expectations grow that AT1 issuance could reach €200 billion, the likelihood of more banks now looking to phase out their existing tier 1 capital throws up pitfalls for the unwary.

Most existing tier 1 securities will carry regulatory par call language, enabling the issuer to call them at par if they become ineligible as regulatory capital. Several banks have recently called such bonds early, and the likelihood of more early calls is growing as AT1 issuance accelerates.

Danske Bank made a cash tender for $1 billion 7.125% lower tier 2 notes in September 2013 at 101.5, while in October Société Générale called $1.5 billion 6.625% lower tier 2 notes at 102. Both had traded as high as 105. Credit Suisse called a $1.5 billion 7.875% tier 1 note early in February.

Given their future need for bank capital, banks are unlikely to want to ruffle the feathers of investors in these instruments. The expectation has always been that banks will avoid making such calls, and if they do that the bonds will be called at a premium to par as a gesture of goodwill to investors.

However, if the bonds fall precipitously on rumours of an early call, that premium doesn’t look quite so generous.

When Lloyds recently announced the LME of a portion of the £8.4 billion enhanced capital notes (ECNs) it issued in 2009, the exchange offer was restricted to institutional investors – retail investors were simply offered the option to cash out via a tender offer with prices ranging from 105% to 144% depending on the security.

The bank discussed the potential for an LME on its non-public earnings call in mid-February, immediately triggering a 10% fall in the price of the 16.125% ECNs.

The Lloyds example demonstrates how by discussing the potential for a regulatory par calls banks have the opportunity to substantially improve the terms on which any tenders are made.

“If a bank discusses in public the possibility of a regulatory call, it is likely that the price of the bonds will fall towards par as the as fears of a call increase,” observed analysts at CreditSights on a recent call. “This would allow a bank to make a tender offer at above par, but at a lower level than it might have done.”

This is what happened in early February when Credit Suisse discussed the possibility of retiring a $1.5 billion 7.875% tier 1 note – the bond immediately fell 3.5 points. The Swiss bank subsequently called it above par at 103 – but it had previously traded at 108.

As more banks look to issue AT1, the chances of them wanting to retire outstanding old-style bank capital will grow. Investors – particularly retail investors – need to be alert to the risks of such early calls – particularly if they are going to be flagged up in non-public analyst calls to which they will not be a party.

Just 12.2% of retail investors took up the Lloyds tender offer – £57.8 million out of £472 million.

“The wording of regulatory call clauses varies widely from [tier 1] security to security, as does the risk of a regulatory par call,” say the CreditSights analysts. “We do not think that most banks will exercise the option, but some are likely to use the threat of a par call to obtain more favourable terms in a liability management exercise.”