Liability management has shown investors its worst side this year. Irish banks upset many creditors by using the threat of even larger losses to strong-arm bondholders into 80% haircuts. And Northern Rocks bad bank aggrieved participants in a sub-par buyback by calling the notes at face value soon after.
But one specialist describes LM as a double-edged sword, because similar techniques can be used to the benefit or detriment of investors. Indeed, more often than not, the tools have been friendly to investors as well as issuers. Through liability management exercises, borrowers have signalled their intentions on an upcoming call, allowed investors to exit issues in size and with pick-ups to secondary value, or given them the option to move up the credit spectrum.
"Investors see liability management as a useful and friendly tool," says Andrew Burton, co-head of liability management at Credit Suisse. "The alternative is private operations where investors potentially miss out on whats going on. Its a mechanism for getting important information out into market, such as signalling that a bond might not be called."
Banks exiting the financial crisis and steering through rocky markets have increasingly turned to liability management. Exchanging and buying back debt are often fantastic options for banks to boost their capital, prepare for new regulations, preserve liquidity or smooth out redemption spikes.
And in spite of this years black marks, debt capital markets bankers say the exercises are here to stay.
"Generally you tend to see more liability management exercises following times of market turbulence," says Andrew Montgomery, head of liability management for EMEA at HSBC. "The fact the markets have had a choppy time in recent months leads you to believe there will be a spate of LMs to follow. Those sorts of market conditions tend to throw out pricing anomalies, which may offer LM opportunities to issuers."
Bondholders protested vehemently in the first half of 2011 when Irish banks offered to buy back debt at close to in some cases below secondary trading levels. Allied Irish Banks offer was preceded by a court order that extended the tenor of most of its subordinated bonds and made coupon servicing optional. Bank of Irelands offer included an equity exchange option at preferable prices to the cash buyback.
Sweep-up clauses, a form of prisoners dilemma, accompanied both capital generation exercises. Investors participating in the exercise automatically approved a change to the bonds terms to allow the borrower to call outstanding securities at 0.01 per 100. In most cases, the sweep-up clauses encouraged uptake: participation rates fell short of the quorum needed to change the terms on just a handful of securities.
For the banks, the exercises generated much needed capital. Allied Irish Banks and Bank of Ireland both booked around 2bn of capital through their exercises. But the operations triggered CDS and, in the case of Bank of Ireland, provoked investors into legal action.
Boosting capital by buying back bonds below par or swapping them into equity need not be unfriendly to investors, though. Commerzbank proved that in January, with an impressive debt for equity swap.
The ambitious operation generated 900m of core tier one capital, out of an equivalent amount of Basel II hybrid securities. The operation was made more complicated by dividend stoppers and pushers on the hybrids. Unwilling to trigger these clauses, the bank executed the exchange in two steps, first raising new equity, and then making the swap.
At first glance, it may seem odd to expect fixed income investors to be interested in an exchange into equity. But while this may not be to everyones liking, the liquidity generated by such offers benefits all investors, says Duane Hebert, head of liability management for EMEA and Asia at Deutsche Bank in London.
"Some strategic investors will be keen to take the equity, but the vast majority will participate in these exercises for liquidity purposes," says Hebert. "They will get a premium to market value, and when the market is very thin and its hard to shift positions, then they can use debt for equity exchanges as means to liquidity."Commerzbanks deal won plaudits from within the investment banking community for its ambitious two-part structure, and was voted top liability management exercise by market participants in EuroWeeks 2011 Bond Awards. Hybrid specialists point out that exchanges of subordinated debt into equity show old-style hybrid capital absorbing losses something regulators attacked it for not doing during the financial crisis.
"Existing capital securities have proven inadequate to the task of absorbing losses dynamically hence some of the changes included in Basel III," says Credit Suisses Burton. "Through the credit crisis, banks have bought back or exchanged capital securities and crystallised losses to bondholders to generate gains that increase core tier one capital. This has allowed the banks to absorb the losses. Even in the case of Allied Irish Banks, where the capital securities were amended to the detriment of bondholders by the state, the economic gains were not reflected into equity for that, there had to be a large scale repurchase. This is where LM has a role to play."
Juggling Basel III and liquidity
While there are large capital gains to be made with hybrid LM, old-style tier two instruments are perhaps an even more popular target for exercises. It has become common for banks, with one eye on Basel III and the other on liquidity, to offer investors to exchange old tier two issues into cash or new securities.
All sizes of borrowers have gone down this route in 2011, from smaller institutions like Italys Banca Popolare dellEmilia Romagna to larger banks like ABN Amro, Commerzbank and Santander.
Their motivations vary. In April, the UKs Co-operative Bank was driven by a desire to keep investors happy and manage its capital base when it exchanged 149.2m of an old tier two instrument, and drew in new cash, for a new £275m 10 year tier two bond. The bank had said it would not call the old bond at its first call date, so offered the exchange to allow investors to exit the old instrument without losing tier two capital.
ABN Amro carried out a similar exercise in April, with Basel III preparations a main goal. Many of its outstanding lower tier twos have step-ups before January 2013, meaning they would lose capital treatment when the new regulatory regime begins to take effect. The bank offered investors the opportunity to switch into new bonds which are likely to be grandfathered under Basel III. Around half of the investors in each bond opted to participate, and, after also bringing in new cash, the borrower was able to print 1.2bn 10 year and $595m 11 year bullet issues.
"There are a lot of legacy capital instruments that are not optimal under Basel III and CRD IV," says Akis Psarris, managing director and head of liability management at Lloyds Bank Corporate Markets. "Banks will look at the stock they have outstanding, and ask how grandfathering rules will affect these.
"Where there are some instruments that amortise or fall out of eligibility, thats the obvious place to start. Banks can take those instruments and turn them into something thats more valuable. But these are very institution-specific strategies."
Another popular exercise is borrowers offering to switch old-style tier two paper into senior unsecured debt. It allows the bank to signal to the market that it may not call a bond at the first opportunity and gives investors an option to exit the old instrument and move up the capital structure.There is an expectation that issuers will call bonds at the first opportunity to do so, and investors have been aggrieved when this has not materialised witness the poor reaction to Deutsche Banks decision in late 2008 not to call a 1bn lower tier two. One liability management specialist said it was "responsible" for issuers to provide investors with an alternative security if they were not likely to call an issue at the first opportunity.
Exchanges of tier two into senior have been particularly interesting for banks in peripheral Europe, with Spanish, Italian and Portuguese borrowers offering such trades.
"Its still very well perceived to call a bond at the first opportunity," says Cédric Perrier, director, FIG and covered bond syndicate at Natixis. "But some issuers from non-core countries are not able to refinance lower tier two. An exchange into senior is very convenient for the issuer and investor-friendly. The issuer secures funding for another five years. And for the investor, they keep exposure to the issuer but gain in seniority and gain in terms of coupon and sell back the lower tier two paper at a cash price higher than the bid they could find in the secondary market."
The strategy worked well for Santander Consumer Finance in late July. More than 80% of the borrowers tier two bonds were tendered for an exchange into senior. The old tier two paid a coupon of 35bp over three month Euribor, stepping up to 85bp over at the first call date in September, and the bank indicated that the economic impact would be a factor in deciding whether or not to call the issue. The bank offered to exchange it for a senior unsecured trade with the same final maturity and a coupon of 160bp over Euribor.
In many instances for regulatory reasons, borrowers cannot categorically state they will not call a bond. Instead, borrowers can steer the market with statements that it will consider the economic impact of a call, for example as in Santander Consumer Finances case. From there, investors can compare the coupon of the outstanding issue with market rates for a new issue and make a judgement on the likelihood of the call.
Signalling is a delicate process though. As much as Deutsche irked investors in the depths of the crisis by simply not calling, Northern Rock Asset Management upset investors when it did call a synthetic RMBS note after indicating it would not.
NRAM bought back eight credit-linked notes below par in a buyback exercise in July, after telling investors it did not plan to call the bonds at the next opportunity to do so the following month. The announcement on the call came with the caveat that the borrower might call the instruments if doing so was in its economic interest after the buyback. The day after buying back over 500m of the notes in the liability management exercise, the bank announced it would call the notes at par.
The transaction worked for this borrower but it would be a risky strategy for many others. As the bad bank of Northern Rock, however, NRAM does not harbour ambitious to return to borrowing, making it less concerned about its reputation with investors.
"If a borrower intends to come back to market, it needs to be very clear in terms of its intentions," says Christoffer Mollenbach, managing director and head of FI debt capital markets at Lloyds Bank Corporate Markets. "Northern Rock was an example of an issuer thats probably not expecting to come back to market. They did buy back at a deep discount and immediately called the remainder at par.
"Whoever took up the LM offer lost significant amounts of money, but if you didnt take it up you got par back. That left the participants understandably quite irate. Thats not an approach you want to use if you want to come back to the capital markets."
European governments opened schemes during the crisis to guarantee their banks borrowings in the wholesale market, in an effort to keep liquidity moving through the system. Banks borrowed billions of euros under these schemes, typically with two and three year maturities, and occasionally in very large clips.
Now the banks are out of the worst of the turmoil, some are keen to present their comeback story, showing the market they do not rely on government support for funding. Others have already started to look at refinancing the debt, knowing that volatile markets make it difficult to predict when new funding will be available. Liability management has an important part to play here.
Caja Madrid, for example, printed a 2bn three year government guaranteed issue in February 2009, and followed up with a similar 2.5bn deal two months later. Add that to the 3bn of GGs issued by Bancaja, with which it has since merged, and next years redemptions look heavy.
Keen to take make a dent in the redemption peak, the banks launched a jumbo exchange offer in 2010. They offered investors the chance to switch out of 17bn of GGs, cédulas and senior unsecured issues maturing in 2012 and early 2013 into three, five and six year tenors. With a 20% take-up rate attributed to the buy and hold nature of investors in these securities the banks extended the tenor of 3.4bn of debt.Another borrower with a hefty GG refinancing task ahead in 2012 was ABN Amro. In April this year, the Dutch bank offered to buy back a 5bn GG issue due to mature a year later. The exercise was part of a funding plan that aimed to cut reliance on short term funding, redeem GG and ECB funding and lengthen the maturities of long term debt.
What next in bank LM?
Liability management will be useful for banks that are assessing their liquidity profiles, bankers believe. A trend for managing government guaranteed, senior and covered bond maturities through LM has picked up over the last 12 months, says John Cavanagh, head of EMEA DCM product solutions and liability management at Bank of America Merrill Lynch.
"Through transactions such as exchange offers and concurrent tenders and new issues, issuers can proactively reduce their refinancing risks by working with existing holders," says Cavanagh. "As some of these transactions can be structured as new money neutral, the supply pressure on the market can be mitigated. I wouldnt be surprised to see this strategy pick up again in the coming months."
Bonds trading at distressed levels will also be targets for borrowers looking to notch up their equity capital with below-par buy backs. That is a trend that could pick up in the periphery, says Jesús Sáez, head of DCM origination for Spain and Portugal at Natixis in Madrid.
"LM will be one of the business lines most considered by Portuguese issuers," says Sáez. "They have some subordinated securities which are quoted at prices well below par. So there is a huge capital gain to be made there, and some investors would be very happy to exit those positions.
"But in the end you have to find the right balance between both investors and issuers. You need to take care of investors, because youre going to need them in future."
And when it comes to transitioning into new-style hybrid capital securities liability management tools are likely to continue having a role. While to date, the focus has been on exchanging into tier two securities that will count under Basel III, tier one is set to become more important in this area.
"There are discussions on regulatory changes to capital issuance requirements and questions around at what point we will have sufficient clarity on what these instruments should look like," says Andrew Montgomery, head of liability management for EMEA at HSBC."As soon as we do, and because the investor universe may be smaller than say five years ago, there will be a trend for capital liability management exercises that lock in existing holders and encourage them into the new-style securities. Those securities that are inefficient from a capital perspective will be targeted."