In May, Royal London, the UK life insurance, pensions, and investment mutual with two million members, 8.7 million policies and £147 billion of assets under management, launched a £350 million, perpetual non-call 10.5 years, restricted tier-1 (RT1) capital issue.
It is the first tier-1 capital issue in Europe since the controversial write-down of Credit Suisse additional tier-1s that briefly saw that whole market trade down to an average price of 83 cents on the euro in March, with some banks’ AT1s trading in the 60s.
RT1s are the European insurance industry’s equivalent of banks’ AT1 capital instruments, designed to be triggered if an insurer breaches its minimum capital requirement or suffers a steep fall in the solvency capital requirement (SCR).
The SCR is designed to keep insurers and reinsurers as going concerns for at least 12 months, with 99.5% certainty, in the wake of unexpected losses from insurance underwriting, from market and/or credit risk in their investment portfolios, or from operational risk.
This was a complicated transaction that took 18 months to structure, in part owing to Royal London, as a mutual, having no common equity into which the instruments could convert.
It might have been better for one of the bigger name national champion insurers to reopen the RT1 market with a conventional deal.
Ready to go
However, Royal London was keen to do a transaction. For insurers regulated under the EU’s Solvency II regime, capital management can be quite dynamic, especially amid the volatility of valuations in their investment portfolios that come with a rising rate environment.
Insurers are held closer to mark-to-market accounting driving their regulatory capital than banks are on their balance sheets.
Insurers also face stricter limits on the proportion of tier-2 and tier-3 capital instruments they can count as part of their SCR. Royal London had maxed out on tier-2, leaving it with no capacity to issue more in a time of future stress. It also wanted to buy in an old tier-2 deal.
Royal London benefited from choosing to control its own destiny rather than waiting for another name to reopen the market
James Whetman, HSBC
“There was a strategic rationale for Royal London to establish access to T1 capital from the capital markets,” Nik Dhanani, head of the global strategic solutions group inside global banking and markets at HSBC, tells Euromoney. “At the end of last year, the company had a modest excess of tier-2 capital, over the amount that could count as regulatory capital for the SCR. Given the company has a tier-2 instrument approaching its call date later this year, it was logical for Royal London to issue the RT1 in anticipation while also enhancing its future financial flexibility by creating tier-2 capacity via the tender.”
While RT1s might be expensive, issuing gives the company greater capital flexibility and so it chose to raise £350 million, paying a 10.125% coupon on RT1s convertible into shares of a special purpose vehicle company guaranteed by Royal London.
Arrangers BNP Paribas and HSBC ran a three-day marketing roadshow, including calls with 50 investors, before pulling in a final order book of £535 million, mostly of conventional UK asset managers along with a few hedge funds.
For good measure, the lead banks ran concurrently the tender for outstanding Royal London tier-2 bonds paying a 6.125% coupon.
Liability management trades are increasingly being run alongside new issues, with the clear implication that investors surrendering old and often illiquid bonds into a tender will receive favourable allocations of the new.
Here, plenty of investors were happy to switch out of Royal London’s safer but lower yielding tier-2s into riskier RT1s yielding maybe 240 basis points more.
James Whetman, managing director in UK financial institutions debt capital markets at HSBC, says: “Royal London benefited from choosing to control its own destiny rather than waiting for another name to reopen the market, not least because one week after the deal, gilt yields had spiked up 50bp to 60bp in reaction to UK CPI data.”
A better tone
We are coming up to two and half months since the Swiss Financial Market Supervisory Authority (Finma), wrote down to zero some $17 billion worth of Credit Suisse AT1s on the basis the bank would not have been viable without extraordinary liquidity assistance loans backed by a federal government guarantee.
No European bank has issued AT1s since.
Is there a read across from the Royal London deal to potential risk appetite for bank AT1s? And could European lenders issue them again soon?
Bank AT1s are a much bigger market than insurance company RT1s and more liquid than bank tier-2 bonds, which credit funds tend to buy at new issue and lock away.
The tone is better now than in the immediate aftermath of Finma overturning the capital structure by zeroing the Credit Suisse AT1s while working out the terms for UBS to pay Credit Suisse shareholders for a bank that the wiping out of a higher-ranking form of capital had magically made viable again.
The lawsuits will run and run on that one.
It is tempting to portray it as an unusual and particularly Swiss event. However, the controversy really harks back to 2011 and the highly politicized process in which the Basel Committee on Banking Supervision issued its minimum requirements to assure loss absorbency in capital instruments at the point of non-viability.
I don’t think the bank AT1 primary market is closed. It is just a question of which institution re-opens the international market and the magnitude of the associated new-issue premium
Nik Dhanani, HSBC
Back then, the Basel committee declared that in the great financial crisis tier-2 capital instruments (mainly subordinated debt), and in some cases tier-1 instruments, did not absorb losses incurred by certain large banks that would have failed had taxpayers not bailed them out.
In fact, holders of those instruments suffered huge losses as the value of those instruments fell in some cases by up 70 percentage points. Euromoney has stood in conferences when enraged investors made this point forcefully to central bankers.
The rules stem from a time when voters and politicians still seethed at the banking industry and anyone enabling it deemed to have got off lightly.
Regulators seem from the very start to have had mixed feelings about AT1s.
The test case of the Credit Suisse AT1s has been a long time coming. It strikes Euromoney as touchingly naïve for any investor to place faith in protestations of other regulators that they would never disrupt the capital hierarchy in the same way their Swiss counterparts have just done.
At precisely what moment did Credit Suisse shift from being non-viable back to being viable again so that equity holders could be paid when AT1 holders were not? Who gets to make that judgement and on what basis?
It would have been better if AT1 holders could have been converted into equity and got even a token amount of money back. But the Swiss authorities knew that weekend that if Credit Suisse went into formal insolvency, then a panic would ensue that would compare with the great financial crisis.
A mish-mash state rescue and private-sector solution had to be cobbled together. Systemic banks are always a contingent liability of the sovereign. But if Swiss taxpayers were to be put at risk, then someone else had to suffer more.
It is almost remarkable that the bid has so quickly returned to the secondary market in AT1s.
Some bank issuers that saw their capital instruments trade in the low 80s at the end of March found them back in the mid to high 90s by the end of May.
“I don’t think the bank AT1 primary market is closed,” says Dhanani. “It is just a question of which institution re-opens the international market and the magnitude of the associated new-issue premium.”
The days when banks could issue AT1s at 5% or lower are long gone. They will probably not have to pay the 16% at which some national champion banks traded in late March. But there has been a repricing. The first issuers back into the primary market will pay substantial new issue premiums to fair value of outstanding deals. And so, the question becomes whether or not the 10.125% Royal London just paid is nearer the mark.
It could be higher though.
There may be a greater volatility in insurance companies’ solvency capital requirements than in banks’ capital ratios, but banks are subject to one extreme risk that insurers are not: sudden and rapid deposit runs.
Yes, insurance policies can lapse. But that is nothing compared with $100 billion of zero cost liabilities disappearing in a couple of days and banks suddenly having to sell so-called hold-to maturity assets that were being valued at cost to pay depositors out.
Capital stacks
In May, the AT1 market was buzzing with talk of discussions led by the European Banking Authority (EBA) over how to rekindle investors interest.
There were differing accounts of the key steps that might be being considered to restore confidence that AT1 is not, in fact, subordinate to equity. But what the talks did most importantly, according to Dillon Lancaster, portfolio manager at fixed income specialist TwentyFour Asset Management, was underline the EBA’s commitment to the AT1 asset class.
“They have invested a lot of time into improving the capital stack of banks – including the AT1 instrument – post the great financial crisis, to make banks more resilient, and are keen to maintain the successful changes made,” Lancaster suggests. “For AT1s to be part of this going forward, levels need to normalize to incentivize new issues and the resumption of a functioning market.”
There are no large banks facing immediate pressure to make economically irrational decisions to issue new high-coupon AT1s to call outstanding deals instead of letting them re-set at now well below the market cost.
However, the main function of AT1s for banks remains. That is to reduce the amount of common stock they must issue and so to boost their returns on equity.
Before long, we will learn where they see relative value in the cost of AT1s versus their own cost of equity.
