Senior unsecured bonds are traditionally one of the most important funding tools for financial institutions. Sitting a rung down from covered bonds, ABS and other secured instruments in the capital structure, they provide a simple form of unsecured funding, free from asset encumbrance and other issues associated with collateralised securities.
But this old capital markets warhorse has fallen on hard times. Changes in the regulatory environment have prompted debate over how secure senior unsecured investments are, and as the buyside reassesses its position, issuers are being forced to consider other sources of funding.
Bankers say the role of the instrument has not necessarily changed. In theory, it still provides unsecured wholesale funding, away from other sources of funding such as covered bonds, asset backed securities and deposits, and it is still one of the most important markets through which banks fund their balance sheets.
But as regulators pile pressure on financial institutions in their capacity as issuers and investors in the senior market the outlook is increasingly bleak for the senior unsecured asset class.
After a brutal summer, which saw spreads hit record secondary wides and not a single issue in the primary market, the eurozone debt crisis continues to take its toll on the blocs financial institutions. But bankers are concerned that even the resolution of Europes troubles will not be enough to rescue senior as an asset class. As one syndicate banker recently put it, its difficult to see any light at the end of the tunnel.
Demand is low and regulation is unclear. Less able to rely on the market, issuers are now having to recalibrate their strategy towards senior.
At the crux of this issue is the perception that senior unsecured bank debt is simply not as safe as it was previously perceived to be. First, seniors declining popularity with regulators has inspired new liquidity rules that are pushing bank investors away from the asset class and into sovereign and covered bonds instead.
Second, the reputation of the asset class has been shaken by the regulatory debate over bail-ins and resolution regimes. In the wake of the financial crisis, politicians and regulatory bodies all across Europe have taken steps to avoid a repeat of the taxpayer-led bank bail-outs of 2008. The bail-in, whereby senior unsecured investors would take a haircut on their holdings when a bank was in difficulty, is one of the principal weapons in this battle.
This adds a whole new dimension to a product that was once as vanilla as possible, says Rob Gardiner, FIG syndicate at HSBC.
"Senior is still required by banks for day-to-day business, but the way some of these new regulations have come out means there will be some add-ons to that day-to-day funding," he explains. "That will make it a more interesting product going forward, and means it cant be as plain vanilla as it always has been."
It is clear the market has a fight on its hands. So what are the odds?
Basel squeezes out bank investors
One of the most important changes has been the gradual departure of banks from the senior unsecured investor community, driven by Basel III and other aspects of the new regulatory environment.
Much of this is down to the controversial Liquidity Coverage Ratio (LCR), a piece of legislation that JP Morgan recently labelled the most "painful" piece of legislation to hit the banking sector so far. Aimed at guarding banks against a run on their funding, the ratio requires banks to hold enough high quality liquid assets to withstand a 30 day liquidity crisis.
Before the credit crunch, over-leveraged banks held large amounts of senior unsecured bank debt and AAA RMBS, mainly because these assets received a low risk weighting from regulators.
Deemed to be liquid, carrying a healthy spread relative to where banks could fund elsewhere and eligible for repo, these assets proved to be far less reliable when the crisis hit. Price volatility was higher than expected and liquidity was lower as was credit quality.
Under the LCR, senior receives a far higher risk weighting. As Andy Young, head of FIG syndicate at Credit Suisse explains, banks are being pushed into the sovereign and covered bond spaces.
"Senior is becoming a less efficient liquidity tool than before, especially compared to covered bonds, let alone government bonds," he says. "In a way, that is the inside track here governments want banks to hold more government debt, so theyre teeing up a larger investor base to buy their bonds, which are generally more liquid than the sorts of bonds they were holding before."
"A significant source of funding has been reduced to the point that it will effectively be turned off once Basel III is implemented," he adds.
But while covered bonds are finding favour with bank investors at the longer end of the maturity spectrum, some bankers are keen to emphasise that financials still show a bid for other banks senior paper at the short end.
"When you look at senior distribution, banks do remain an important element," says Caroline Bryant, head of FIG DCM for Nordics and Netherlands at Natixis. "At the short end, youre talking about 50% of the book."
Running for cover
Bank investors are not the only ones to be running scared from senior. Even if senior was unaffected by the LCR, the bail-in debate would still raise serious questions about the security of the asset class. Fears around resolution regimes threatened to close the senior FIG market in early 2011. Since then, spreads have widened steadily the iTraxx senior financials index has gone from 121bp in April to a record high of 320bp in September and issuers have turned to the covered bond market for cheaper funding.
"Covered bonds have gained importance in terms of playing a more significant role as a funding tool for banks," says Bryant at Natixis. "Indeed they provide cheaper and longer duration funding and are by and large subjected to less execution risk and market volatility than unsecured funding."
But banks cannot fund solely through covered bonds, and the bail-in issue has weighed heavily on investors minds throughout 2011. But other problems have eclipsed the ghoulish glow of the bail-in the eurozone debt crisis, for one.
Proposals from regulators suggest that, from 2013, all outstanding senior unsecured debt would be accessible under bail-in and resolution regimes. Rationally, this should imply a steepening of credit curves, but after a year of turmoil in both the sovereign and banking sectors, investors have had bigger fish to fry.
"We have not really seen that steepening," says HSBCs Gardiner. "Clearly spread direction is being dominated by other factors and there is still a lot of definitive guidance needed on bail-ins before firm conclusions can be drawn. Other macro news and events have stolen investors focus.
"On the senior side, the investor base has not fundamentally changed as much this year as yet. Once the bail-in laws have been fully digested we may see further development of the investor base between the two asset classes."
Make no mistake, however the issue is at the forefront of the investor communitys consciousness.
"The bail-in debate is definitely affecting investor appetite for senior unsecured bank debt," says Caroline McQueston, financials credit analyst at Bluebay Asset Management. "We feel that European banks are not as strong as they need to be for something like this to come in.
"US banks are in a better position they had huge recaps, have mostly paid back TARP, and are now subject to a resolution regime under Dodd-Frank. In Europe we have Basel III but its not active yet and there has not been enough recapitalisation. With the eurozone sovereign situation still unresolved we doubt investors will be comfortable buying large amounts of bail-inable debt from European banks."
Some investors, however, are more sanguine about the future of senior, not seeing a material difference in risk. And looking at the bigger picture, one can understand why.
Many market participants argue that because Basel III will force banks to hold a great deal more capital than they do now almost 50% more the possibility of a bail-in actually happening is more remote. The risk on the instrument is higher, but in the context of better managed banks, there is an argument that says investors are almost in a better position than they were before, even if regulators eventually make them junior to retail depositors."If you have senior unsecured risk on a bank that is running a 10%-12% common equity ratio which five years ago would have been 5%-6% you probably have a safer instrument and a more resilient financial system," explains Young. "And that may be a safer place to be than ranking pari passu with depositors in an under-capitalised system."
This, argues Olly Sedgwick, head of FIG syndicate at Goldman Sachs, will force issuers to build a capital structure and a funding mix that convinces investors of their solidity and allows them to access the senior market at feasible levels.
"To sell bail-inable senior unsecured debt, you have to convince investors that the risk of a bail-in actually happening is remote," he explains. "Once Basel III is enacted well find out what level of capital is adequate to convince investors of that.
"Banks have gone from having about 4% total tier one, of which maybe 2% would be core, up to 10% so almost five times more capital. And that is in a world where balance sheets have deleveraged as well. It also depends on what sort of assets and risk model you run. The riskier it is, the more capital you want to hold, because you have a greater chance of your capital degrading in a downside scenario."
Although issuance of contingent capital has been mooted for banks in many European jurisdictions, those institutions that are required to issue them believe they will have a similar effect, making senior investors feel better protected."The trigger mechanism in a low-trigger Coco bond is very similar to a bail-in and that will provide a very important extra layer of support for senior bondholders," said Kim Fox-Moertl, Head of Capital Management at Credit Suisse.
Still space for senior
What do these changes mean for issuers in the senior unsecured market? Covered bonds provide an alternative source of funding, but banks do not have limitless supplies of collateral. This means that senior is still a key tool and there are other markets outside Europe.
"The European market is only one slice of the pie that is available to me as an issuer," says one funding officer. "Obviously there are significant issues relating to resolution regimes and senior unsecured as an asset class but sentiment differs greatly between jurisdictions and different communities of investors.
"The US market, for example, was there at the start of the year when European investors shied away because of bail-ins. They have already seen bail-ins and can look back on that experience, so its not so much of an issue for them."
He also argues that the fact that banks are running out of collateral will force credit investors back into the senior market.
"If someone wants to buy our paper and there is no more covered issuance coming, senior unsecured will be the only option in the public market," he explains. "A lot of the big investors like Pimco make their decisions based on credit anyway, so its not like all the demand has been sucked out of senior."
Because covered bonds and subordinated debt generally fulfil longer term funding requirements, many issuers see a shift in the use of senior towards short-term funding, a trend that has been reflected in issuance over 2011.
"In Switzerland, we have this requirement that we have to issue Cocos, so one consequence is that part of our longer term funding will be issued in that form," said Rolf Enderli, Group Treasurer at Credit Suisse. "So, for us, it's clear that senior funding will be issued more in medium maturities going forward, five to three years. We still have some longer term senior outstanding but that will gradually be taken over by cocos. Senior long-term funding has gone down in importance for us."
But rising spreads and the extra demands placed on banks in terms of capital could create challenges for smaller issuers, as investors look for extra security on a less secure instrument.
"Senior will still have a role for banks but some of these new regulations will make it a more credit-intensive product, and not as plain vanilla as it was previously, with investors more focused on capitalisation, encumbrance and ultimately on recovery rates," says HSBCs Gardiner. "The pricing impact for the top tier, crème de la crème issuers who are well capitalised, is likely to be lower than that for the second or third tier issuers."
This pricing impact goes further than just senior unsecured as a product. Many are concerned that smaller banks, unable to run capital ratios as large as SIFIs and other large institutions, will be shouldered out of the market altogether.
"One of the unintended consequences of all this is that its going to start to get very difficult for small banks to compete," explains Young. "Because, by definition, they are not SIFIs, even though the regulator isnt forcing them to hold more capital as the big banks, the necessity of accessing senior unsecured at competitive levels will force them to hold significantly higher capital ratios.""That will make it more difficult for them to compete on the asset side, and will lead to significant consolidation within the financial system."