European banks planning to tap what has become a much more circumspect subordinated debt market this year can draw solace from a tier-2 deal from Deutsche Bank in mid-May. The German lender’s first capital issuance for more than a year came in the wake of a market sell-off in February, in which its own additional tier-1 bonds were at the heart of the panic after it reported a €7 billion annual loss.
Deutsche is paying a coupon of 4.5% on the new notes, way above the 2.75% it paid last time it issued 10-year tier-2 debt in euros, in February 2015.
Jonathan Blake, head of issuance, says it was also harder than normal to gain investors’ attention, as corporates squeezed in pre-summer issuance plans between the February sell-off and June, a month likely to bring further volatility with the Spanish elections and the UK’s referendum on the EU.
Nevertheless, its order book reached €1.7 billion. “We could have issued €1 billion but we decided to do a smaller deal to make sure the notes performed in the secondary market,” says Blake. The bank issued €750 million, and saw the bonds rally.
Better macro-economic news, including the European Central Bank’s March announcement of a new package of measures, has helped ease conditions in the subordinated debt markets. Moreover, bankers say statements from the ECB and others suggest an imminent legislative change to allow more flexibility to make payments on tier-1 bonds in the event of an annual loss leading to a fall below pillar-two capital requirements – or at least greater appreciation of the new bail-in framework’s problems.
The tier-2 bond should be seen alongside a first-ever quarterly results call with fixed income investors in late April, and Deutsche’s biggest-ever senior unsecured issue in dollars ($3.6 billion) a few days before the tier-2 issue, according to Blake. He says it was all part of “a strategy to re-engage with fixed income investors”. Before the tier-2 deal, a roadshow to London and Paris aimed to clarify its credit position to investors.
“We wanted to do a more challenging transaction to show that after the turbulence in February we still had access to the market for capital securities,” says Blake. Additional tier-1 bonds are still “in the tool box but there is no hurry” to issue, he adds.
Barclays’ Contingent Capital Bond Index was down 4% year-to-date on the day Deutsche’s tier-2 issue was priced. Other bankers still doubt that names like Deutsche Bank or UniCredit can issue additional tier-1 bonds at a cost that would be viable compared to equity. Among European banks, UniCredit is closest to a capital ratio level at which it could face mandatory restrictions on AT1 payments, according to CreditSights.
Most of Europe’s 13 other global systemically important banks (G-Sibs) can now feasibly issue in the format, bankers say, although banks without a pressing need are more likely to wait for greater regulatory clarity on allowable disbursements, in the hope of cheaper prices.
UBS was the first European bank to issue AT1 after the sell-off, a $1.5 billion deal with a coupon of at 6.875% in early March. Issuers including Bankinter, BBVA, and Rabobank have since followed, though the Spanish banks are paying a coupon over 8%. Deutsche’s tier-2 issuance came in the wake of deals in the same format in March and April by banks including Commerzbank, ING and Santander, at coupons of 4%, 3%, and 3.25%, respectively.
Forgotten asset class
Tier-2 debt has been a “forgotten asset class” in recent months, says one capital products banker, amid uncertainty over how European states and banks will implement TLAC (total loss-absorbing capacity) rules and MREL (Minimum requirement for own funds and eligible liabilities).
Under Basel III, banks can use tier-2 debt to fill up to two percentage points of their pillar-one requirement, compared to 1.5 percentage points for AT1, which were the focus for the panic in February. “In difficult market conditions, banks are more likely to do tier-2, as you saw at the start of the year,” says Simon McGeary, European new products group head at Citi.
The ECB’s endorsement of European Banking Authority guidance in late December, saying pillar-2 requirements should be factored into maximum distributable amounts (MDA), was one the main causes of the sell-off. It is relevant to AT1 but not tier-2, whose coupons payments can only be suspended in more extreme situations.
However, says one banker, investors have been hanging back from buying tier-2 debt in the secondary market due to expectations of a potential increase in supply. “We’re expecting there will be growing supply of tier-2, as issuers look for the optimal capital structure under TLAC and MREL,” adds McGeary. “When senior debt can be bailed-in, investors will take comfort from thicker layers of tier-2.”
After Germany amended legislation to subordinate senior unsecured securities to other senior unsecured liabilities, potentially a model for elsewhere in Europe, Rabobank said it would seek to increase its total capital ratio (including tier-2) to 25%, to add comfort to senior unsecured creditors. However, says another banker, in practice the cost of building up tier-2 buffers could outweigh the benefit to senior unsecured bond prices. Moreover, French banks may soon have the option of issuing a third tier of non-preferred senior unsecured bonds.