UBS’s uneconomic call cheers AT1 market
AT1s rallied on news that UBS will redeem a key deal in January. But with refinancing costs higher than coupon re-sets, the pressure now passes to other big banks.
UBS announced on December 5 that it will redeem the $2 billion additional tier-1 deal it first issued back in January 2018 with a 5% coupon on its first call date at the end of January 2023. The cheers resounding around bank debt capital markets desks at the news were louder than for any World Cup goal.
“That issue was the elephant in the room for European AT1s,” says one banker. “It would not have been OK if UBS did not call it. And there was huge relief when it did.”
Rising rates have changed the economics of AT1s. Banks that used to issue at 5% coupons are now paying anywhere between 8% and 9%.
AT1 deals have to appear, nominally at least, to be perpetual in order to secure capital recognition from ratings agencies and regulators. But normal practice has been to call on the first possible date. The incentive for banks to do this – and the compensation for investors if they don’t – is that coupons re-set higher after the first call date.
But that incentive no longer applies and the UBS deal had been looming as the key test.
It has a re-set to a 243 basis point spread over mid-swaps. That would have seen the bank paying around 6.375% if it had chosen to extend the life of the instrument, rather than the 5% cost over its first five years.
A reset spread that seemed punitive when the deal was issued now looks like a gift. UBS would struggle to sell a new AT1 deal with a coupon anywhere near 6.375% today.
Credit Suisse is a very different beast, with continued operating losses and restructuring expenses recently requiring it to raise expensive new equity at a sharp discount to an already depressed stock price.
Back in June 2022, the bank famously paid 9.75% to refinance an AT1 coming up to its first call date at the end of July. Its woes since have seen credit default swap spreads periodically gapping out and those new AT1s trading down below face value to yield 20% at one point.
Back in October, the bank had talked of selling more AT1s, along with senior non-preferred holdco debt, before the end of 2022. But that will not happen now. It announced on completion of the rights issue on December 8 that it had finished issuing for the year.
Regulators have mixed feelings about AT1s. If standard practice is to call them even when doing so is quite clearly uneconomic, can they really be classed as perpetual?
UBS bears no comparison these days to its big Swiss rival. It would not have to pay 9.75% to issue a new non-call five AT1. But it might have to pay anywhere in a range from 7.75% to 8.5%, according to FIG bankers, so perhaps 200bp more than the re-set.
“The call is blatantly uneconomic,” says one FIG DCM banker.
That is why the transaction has been so closely followed. Everyone in the AT1 market has been talking about the UBS deal since it began trading well below face value – at one point in October 2022 reaching 86% – on growing fears of extension.
The decision to redeem was a welcome surprise, albeit one that had begun to be priced in as the old deal traded back into the mid 90s. UBS has not said how it will pay bondholders, raising the possibility that it might even eat into its high cushion of common equity tier-1 capital, which stands at 410bp above regulatory minimums, giving it some $13.9 billion to play with.
That would be very expensive capital to use, but would emphasize its strength. UBS may be thinking of an investment in its weighted average cost of capital right across the entire stack of debt and equity.
When it announced its intention to redeem, UBS hinted at the complexity of the decision, saying that this “reflects UBS’s long-standing call policy, which is to carefully evaluate all relevant factors, including the market environment, economic costs, business growth and funding plans, as well as the current and future regulatory value of the capital instrument”.
Regulators have mixed feelings about AT1s. If standard practice is to call them even when doing so is quite clearly uneconomic, can they really be classed as perpetual? Surely that looks more like a pretense to capture the benefit of accounting proceeds as capital while pocketing the tax saving from paying debt coupons rather than dividends.
Has it all become all just a little too cute for comfort?
Dillon Lancaster, portfolio manager at TwentyFour Asset Management, makes the case: “For a bank like UBS, which has many different units with different interests, not to mention a large debt stack made up of everything from multiple AT1 issues to senior unsecured bonds, it is not necessarily the short-term economics of a call driving the decision; the desire to be considered in the very top echelon of banks in terms of practices and bondholder relationships also plays a part.”
Puja Karia, senior analyst for European banks at CreditSights, points out: “UBS is one of the best performing European banks, with strong capital ratios and a track record of redeeming callable bonds. We believed it would want to preserve this record, despite the economics of calling.”
While the face value of its AT1s traded up around 1.5 percentage points on the day the news broke, Lancaster suggests that announcing its intention to redeem should result in the rest of UBS’s debt stack trading tighter over time.
More broadly it might also provide a reminder to the investors that most European banks are well capitalized and will endeavor to exhibit “best practice”, which means calling deals. Karia suggests “non-calls will be the exception, rather than the rule”.
Banks certainly have an incentive to keep the AT1 market alive. Paying 8% to 9% may look expensive compared with the 5% coupons that prevailed just two years ago, but that is still cheap compared to banks’ cost of equity, now in the mid to high teens.
But while wider credit spreads push the costs of refinancing with new AT1s well above coupon re-sets on existing deals, the probability of non-calls will remain a concern. No sooner had UBS announced its intention to redeem than attention switched to big AT1 deals from HSBC and Barclays coming up to their first call dates in the Spring of 2023.
“Who wants to carry the stigma of being the first big issuer not to call? That and the true all-in cost of not calling is what we are all trying to assess,” says one FIG DCM banker, while admitting “no one has the answer.”