But a medium-sized Portuguese lender, Banco Comercial Portugues SA, has shown a middle ground to keep both investors and regulators on the sidelines. It could have the welcome effect of reducing the increased premium for holding extendable debt from financial institutions.
Bank debt is specifically designed to absorb losses when banks run into trouble, either through write-down or conversion to equity. The riskiest type is Additional Tier 1 debt — often known as contingent convertibles, or CoCos for short — the most subordinated type of bank debt, with the (usually sophisticated) investor hooking up for the full amount. Therefore, the yields are much higher than what is available on regular bonds.
This is perpetual debt, with no maturity date, because it is equity that supports the entire balance sheet. The sweetener is that these usually have call options after five or ten years, allowing issuers to redeem early. Tier 2 debt, such as the BCP deal, ranks slightly higher in the capital stack because it has a fixed maturity and call options.
However, there is no guarantee that investors will be repaid early. In good times, these types of bonds tend to be the most lucrative bank debt available; but renewal risk has compounded their yields this year.
European investors typically expect banks to redeem and refinance these bonds as quickly as possible, even if it is unprofitable for the issuer to reissue similar debt at higher interest rates. However, this treaty is increasingly frowned upon by the European Central Bank, which wants everyone to recognize hybrid debt as permanent equity rather than regular debt financing. It requires banks to seek its approval when activating call options to ensure they do not jeopardize solvency. The regulator wants to avoid systemic risk if refinancing actions increase the risk of bank failure; official bailouts, as they often did during the euro crisis a decade ago, have become politically toxic. BCP follows ECB guidance by skipping December’s call for its €300 million ($290 million) Tier 2 bond due 2027, but softens the blow by offering a buyback of this bond in a new deal with a higher coupon and a longer duration. So while bondholders won’t get a full repayment on a bond that trades 80 cents to the euro in the mid-80s — which they would if BCP activated the call option — they’ll likely receive a level higher than the market price. Investors offering the existing deal will likely receive full allotments for the upcoming replacement. The key for the regulator is that at least the same amount of Tier 2 capital is retained, as the original bond remains, albeit at a smaller size, and the new instrument fills the shortfall at a manageable additional cost to the bank.
Similar liability management exercises, or buybacks, have recently been undertaken by a UK bank in its AT1 bond, Shawbrook Group PLC, and even by a restructured German lender, Hamburg Commercial Bank AG, in its senior non-preferred debt. Bloomberg News has listed upcoming calls for AT1 debt for next year. Austrian lender Raiffeisen Bank International is the next European institution with an AT1 call date, mid-December.
There is no set rule for skipping calls. While investors understand that issuers can do whatever they want in the prospectus, European banks have typically used the options to keep investors happy. The situation is different in the US, where bondholders expect borrowers to take the most cost-effective route when deciding whether to refinance existing debt.
But due to much higher yields, it is increasingly in the economic interest of European issuers not to refinance. Spanish lender Banco de Sabadell SA opted last month to skip the call on one of its AT1 deals. Nevertheless, Barclays Plc recently abandoned an existing AT1 deal and reissued similar debt at a significantly higher cost. Credit Suisse AG also did something similar, although this was part of a larger restructuring package that also included debt repurchases. However, these entities are not primarily controlled by the ECB, but by the Bank of England and Swiss regulator Finma respectively.
The management of any bank deciding whether or not to waive call options must weigh the impact on future investor readiness against the wishes of the regulator. If the overall effect on the bank’s capital stack is broadly neutral, market regulators should be flexible in these turbulent times. Being left out of the riskier part of the debt market is a fate no institution wants to suffer, as it can drastically reduce its ability to operate. Over-regulation can be as much a systemic risk as too light a touch. The ECB needs to go with the wind where it can while maintaining the general direction of the European capital market for banks to get closer to the US model.
More from Bloomberg’s opinion:
• The Credit Suisse foundation begins to crack: Paul J. Davies
• The banking market where profit is guaranteed: Marc Rubinstein
• ECB empties the punch bowl for economics and banks: Marcus Ashworth
This column does not necessarily reflect the views of the editors or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Prior to that, he was chief markets strategist for Haitong Securities in London.
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