The recent surge in issuance of Basle III-compliant bank capital securities in Europe seems to reflect growing investor confidence in these bonds previously confined to the most exotic corners of the capital markets. However, as European banks lick their lips at the prospect of billions of euros of cheap new capital, doubts remain that alternative tier 1 (AT1) securities can necessarily make it as an asset class.
One of the profound conceptual changes brought about by the new regulatory framework has been that fixed-income investors, previously insulated from the most exposed rungs of the capital structure, must pull their weight in protecting taxpayers from institutional bankruptcies. That has been achieved by the inclusion of conversion features and write-downs in contingent convertibles (CoCos), areas of risk previously reserved for shareholders.
The Basle rules represent a basic standard, and in recent weeks national regulators have implemented their own rules, with the UKs Prudential Regulation Authority requiring that big UK banks and building societies meet a 7% core equity tier 1 capital ratio and a 3% tier 1 leverage ratio from January 1 2014.
Confirmation of the rules has spurred a recent surge of AT1-compliant issuance, with Barclays and Credit Suisse at the vanguard.
Barclays followed up a recent dollar deal with its inaugural euro-denominated CoCo, a 1 billion 8 % perpetual. Credit Suisse meanwhile sold $2.25 billion of 7.5% perpetual bonds. Between them the banks attracted an extraordinary $35 billion-equivalent of orders; an orgy of demand that seemed to lay to rest earlier concerns that deferrable coupons and equity conversion was not a recipe
that would sit easily with fixed-income mandates.
From the bank point of view the circa 8% coupon amounts to cheap capital when compared with the cost of equity, currently running at 10% to 12% for European banks. In addition, AT1 securities are more tax efficient than equities, with coupons deductible in most European jurisdictions.
According to Barclays some 61% of investors in its latest CoCo were fund managers and 21% were hedge funds. Private banks comprised 9% and insurance companies and pension funds 5%. UK investors took half the issue, with the US accounting for 13%.
|Daniel Fairclough, managing director, UK financial institutions, at Barclays|
Still, not all investors are enamoured of CoCos, and some express concern that bond investors are the victims of a kind of regulatory confidence trick.
"The main issue with CoCos, and the reason we will not buy them, is that bonds are supposed to be senior to equities in the capital structure. Under this arrangement that basic concept can be turned on its head," says Patrick Vokel, head of European credit at Schroders in London. "Investors may get tempted by the high coupons on offer but they could end up getting bitten, and for me the coupons do not offer adequate risk-adjusted returns."
One way in which some CoCo issuers have attempted to comfort investors over the prospects of being treated equally to equity, or even subordinated, is by the use of what are called dividend stopper clauses. To qualify as AT1 securities CoCo coupons must be fully deferrable, which in the eyes of some funds would only be acceptable if non-payment is accompanied by withdrawal of share dividends.
The problem with dividend stoppers is that they are prohibited under Basle III, giving banks from outside the EU, such as Switzerlands Credit Suisse, a nice advantage, and perhaps partly explaining the banks recent ability to print CoCos 75 basis points cheaper than Barclays.
"The dividend stopper is good because at least it means the bond investor wont get treated worse than the equity investor," says Vokel. "The ability of Swiss banks to include those clauses makes those deals slightly more attractive."
Dividend stoppers are just one challenge in building CoCos into a bona fide asset class, and the bonds are still characterized by considerable variation in their structures.
One example is call periods. Société Générale in mid-December launched a $1.75 billion perpetual AT1 with a coupon of 7.875%, attracting $17.5 billion of demand for the deal. The bond is callable after 10 years, while Barclays recent deal is callable after seven years.
Unlike some previous CoCos, which were not rated, Société Générales bonds were rated BB+ by Standard & Poors, BA3 by Moodys and BB by Fitch.
"We attracted a wide range of investors from the US, Europe and Asia, with real-money accounts in the book in every region, and most of the accounts being well-known asset managers," says Vincent Robillard, head of group funding at Société Générale.
According to the Bank for International Settlements quarterly review published in September: "The absence of a complete set of credit ratings for CoCos has been a significant hurdle on the growth path of this young market."
Another reason why investors liked the SG bond, Vincent says, was because it contained a temporary write-down feature in case of trigger breach. Write-down has the same impact as conversion, which is to raise effective levels of equity.Customization
Another area of customization is around the trigger, which can be set based on a mechanical rule or supervisors discretion. The mechanical measure can be based on book or market values, neither of which are particularly easy to model. Calculation of book value is based on internal bank models, which are rarely consistent, while market-value triggers can lead to so-called CoCo death spirals, in which it might pay some investors to short the stock to force the CoCo to trigger.
The third species of trigger comes under the rubric of point of non-viability (PONV) and is at the discretion of the regulator, which can intervene if it believes action it is necessary to prevent insolvency.
A big difficulty for investors is pricing the optionality in respect of triggers and coupons. As both of the variables are qualitative, that is almost impossible with conventional solutions, which rely on quantitative inputs.
For some US-based investors the solution has been to ignore outcomes that cannot be modelled and focus on investment returns, individual bank credit quality and the positive story coming out of European banking.
"In the US if you want to earn 7.5% or 8%, you need to look at the distressed market, so on that basis they are attractive," says Matt Minnetian, a senior portfolio manager at Alliance Bernstein in New York. "We understand that there are challenges with valuing coupons deferrals and other soft aspects of the deal, but the credit work we do around these bonds is intense, and that includes talking to senior management to understand their incentives and regulatory constraints. Obviously what you dont want is to end up with a non-paying perpetual security."
As investors weigh the risks of multiple pricing parameters and qualitative outcomes against the benefits of higher coupons, banks look set over the coming months to continue issuing new deals. Analysts at JPMorgan estimate that to meet capital requirements by the end of 2014, banks will need to issue at least 31 billion of tier 1 capital, with AT1 being theoretically the most attractive option. Barclays Fairclough estimates that the market might eventually reach 300 billion.
Although recent appetite for European bank debt has been impressive, some analysts argue that demand is more a reflection of recovery following the financial crisis than a long-term structural shift in demand. How the market eventually pans out, say analysts, will depend on whether or not mainstream institutional investors can swallow the format.
"One of the biggest concerns about the asset class is whether there will be a broad enough investor base," says Roberto Henriques, a credit analyst at JPMorgan. "Right now AT1 are not included in benchmarks and I would say we are at a stage where the big real-money guys are evaluating the opportunity."