AT1: Par call pitfalls

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Lloyds LME highlights potential risks to investors of early regulatory calls in the booming AT1 market

The impact of CRD IV combined buffer requirements that are due to be phased in over a four-year period from 2016 are already clear to see in the booming bank capital market. As expectations grow that AT1 issuance might reach €200 billion, the likelihood of more banks now looking to phase out their existing tier 1 capital poses 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, including Danske Bank, Société Générale and Credit Suisse. All were called at premiums to par.

Given their future need for capital, banks are unlikely to want to ruffle the feathers of investors in these instruments, so these par premiums can be seen as a gesture of goodwill to investors. But if the bonds fall precipitously on news 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 ($14.1 billion) of 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 announced it was considering an LME on its non-public earnings call in mid-February, immediately triggering a 10% fall in the price of the 16.125% ECN notes.

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

This is exactly what happened in early February this year 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 and more banks look to issue AT1, the chances of them wanting to retire outstanding old-style bank capital will grow. Investors, especially retail buyers, 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.

"The wording of regulatory call clauses varies widely from [tier 1] security to security, as does the risk of a regulatory par call," say 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," they warn.