Participants in this discussion, which took place in December 2009 in London, were:
Michael Gower, head of long term funding, Rabobank
Damian Chunilal, founder, The Capital Securities Fund. Former head of Merrill Lynch Pacific Rim Investment Banking and before that head of Merrill Lynch EMEA DCM and founder of its FIG DCM business
Bryn Jones, fixed income fund manager, Rathbone Bros Plc
Matthew Rees, senior credit analyst, Legal & General Investment Management
Lionel Trigalou, CFA, senior credit analyst, Insight Investment Management Ltd
Lucette Yvernault, global credit portfolio manager, Schroders
Toby Fildes, managing editor, EuroWeek
EUROWEEK: Michael, as an issuer, what were your worst fears in 2009 and did any of them play out?
Gower, Rabobank: Our main fear initially was the lack of a level playing field. We had a genuine concern that banks which had essentially failed, for want of a better word, would be able to benefit from a government guarantee and government support and therefore, from a pure credit perspective, would be viewed as a better safe-haven than Rabobank. Frankly whats the point of being conservative if, when you need to be conservative, theres no benefit?
Ironically what actually happened was the converse and we were under pressure, domestically, to be part of the government guarantee scheme. We felt it was not necessary either for our own wellbeing or for the wellbeing of the system, and that was one of the prime reasons behind going into market with a very large deal early on in January.
EUROWEEK:What was it like building up to that deal?
Gower, Rabobank: We thought it would be a success because of the pricing in hindsight it was a lot better for investors than it was for us. But frankly at that point in time my discussion with board level management was not about price but about liquidity and access. It was all about getting in the volume that we needed and demonstrating to the market that, number one, from a credit perspective we were okay, two, we had access to liquidity, and from a lesser but more altruistic standpoint, three, saying to the European banking system, look, there is a standalone senior liquidity option available to everybody because otherwise banking as an industry would become nationalised and we would be going back almost 100 years in terms of what banks were and how they could fund themselves.
So, January for us was very much make or break in terms of how we had to fund our own balance sheet and capitalise ourselves in the market.
EUROWEEK: Did you have any sleepless nights?
Gower, Rabobank: It seems amazing now to think that triple-A banks were paying 150bp over in five years. But at the time the pricing transparency was absolutely zero.
The sleepless night I had was on January 13 before we went into the market with the deal. But we took a view, we led the market on price and said this is where its going to be, we think its value.
We certainly didnt expect the Eu7bn order book. In hindsight it was, as they say, blindingly obvious that a lot of credit investors were suddenly interested in those type of levels. People took it as a sign of good news, a bit of strength, markets perhaps reopening, but that was quite a nervy night.
Of course conditions have been much better since then, but were glad we did it. It was the start for us if not the rest of the financial sector at least the wheels were beginning to turn again.
EUROWEEK: Was the deals success surprising?
Jones, Rathbones: Over the last 12 months there has been a lot of cash coming out of other asset classes there is so much cash swilling around earning very little that when a FIG issuer comes to market investors have just been piling in. Theyre getting 0% on their bank account; for taxpayers at the front end of the curve, there are only two Gilts under five years that after 40% tax are giving you a positive return. People are worried about getting their fingers burnt in the equity market. It was clear that any issuer coming to the market would see a lot of demand, and weve continued to see that all year. Weve seen some order books sometimes 10, 12 times oversubscribed.
Yvernault, Schroders: Im not sure about the "tourist" nature of large institutional inflows into the corporate asset class. Weve picked up a lot pension plans which are changing their allocation towards fixed income over time. The same with the insurance companies we all know some had already purchased fixed income FIG instruments in the past but more of them are coming on board thanks to the great yield opportunities we have seen over the last year.
The big question is whether they will remain in the asset class if yields are not quite as good as they have been in the past year. I dont think that 2010 will be about reallocating to another asset class primarily because all the asset classes equity, commodities, emerging markets, etc also did reasonably well last year and there are no areas that are now expected to contract sharply this year, having missed out on the great contraction of last year.
Rees, Legal & General: I agree with you on the institutional space but I think that theres a lot of retail investors that have jumped into this market and theyre concerned about potentially rising Gilt yields, they dont actually care about the spread too much, they just care about the yield theyre obtaining. If we get pressure on government bond yields then we might see retail investors exit the asset class somewhat.
Gower, Rabobank: Weve always placed a lot of product into retail away from the UK as the UKs never been really a traditional retail fixed income investor base.
That has changed over the past 12 months, particularly over the last six months. The traditional time lag between markets becoming interesting and retail getting involved has narrowed and certainly in terms of high rated, higher yielding product, in the tier one space particularly, the UK retail distributors and even retail investor base have become increasingly active.
Chunilal, The Capital Securities Fund: When we talk about fears and whether they played out or not, clearly the overriding thing in our mind at the beginning of the year was systemic support. Was it going to be given and was it going to be given in a way that was credible and in a way which would create a framework within which investors could make investment decisions knowing what the rules were. And, certainly, towards the end of 2008 we didnt have that; Washington Mutual, Fannie Mae AIG, Lehman what would have happened to Merrill Lynch had it gone? In all of those situations there was no clear set of rules.
Following the high level of systemic support that was given there was a set of rules. Our main concern then became firstly, whether the authorities would execute within these rules, ie were these rules going to be credible, and secondly, when we saw government support for systemically critical institutions, and Im distinguishing between those institutions that are systemically critical and those that are not, would creditor rights be preserved and respected.
Certainly our big fear was that this might not happen in the United States. At that time we didnt invest in any US debt securities because we were very concerned about whether enough support would be given and whether creditor rights would be respected, particularly after Washington Mutual. That was, for us, a fairly horrifying situation and set a very bad example for other situations, whereas in Europe, particularly in continental Europe, we felt much more confident with the way the authorities would work. We felt that the investing traditions and the institutional framework was such that creditor rights would be respected. That didnt mean that one couldnt lose money in certain situations. The German loss absorbing tier one instruments, are an example.
Clearly in some cases there were principal writedowns and there were coupon deferrals, but for us that was fine because they occurred within the clearly defined contractual framework of the specific securities. Therefore, I think two of our worst fears were not realised and that gave us a lot of confidence in this sector as we came into March.
EUROWEEK: How did the introduction of the government guaranteed asset class affect you?
Yvernault, Schroders: Its interesting as a class because obviously there are two sides to it. You either consider that the bank itself will repay its coupon and principal liabilities, or you consider that the local government will eventually need to step in and cover the repayment cash steam.
We believe that the first scenario is our favourite one. We wouldnt like to lend our client money to banks which arent able to satisfy their initial obligations due to balance sheet difficulties.
We used government guarantee early in the year in a number of our portfolios, including the short term ones. At the time, liquidity was greater than in the non-guaranteed market and spread levels were still attractive. For me, it was important to rebuild confidence in the banking sector and this was clearly a very effective way to reopen the market. If I look back now, volume of government guaranteed financials issued last year accounted for no more than half the volume of financials issued in 2009. This would indicate that the public debt market has now mostly reopened to the vast majority of institutions. Going forward, I hope that this kind of emergency measure will be used wisely and solely in very select instances.
Trigalou, Insight Investment: As an analyst, the guaranteed debt did not really concern me, because there was no real credit work involved and the decision to invest or not was more an arbitrage made by my colleagues on government desks. But that was clearly a fundamental step to allow confidence to come back and allow banks to issue on an unguaranteed basis again.
EUROWEEK: Have you sold your government guaranteed bonds?
Jones, Rathbones: We invested in some of the government guaranteed bonds at the start of the year because the spreads were more attractive versus some of the triple-As we were holding. So on a relative value basis we were switching into those and taking the premium but subsequently theyve rallied pretty much back to where existing triple-As trade so we no longer hold them.
What is most interesting is what they did to the indices, because if you think before the crisis you had all this sub debt in the iBoxx investment grade index that got completely creamed so the iBoxx index fell pretty aggressively. All the rating agencies downgraded most of the sub debt which then went into the high yield indices. The sub bonds have subsequently rallied in the high yield indices, so anyone diligently following the investment grade index wouldve basically got creamed in sub debt on the way down and not taken advantage on the way up.
Meanwhile the investment grade indices became full of government guaranteed debt. So that was the key issue for us and the decision we made for the fund was basically, well, no, were not going to take the downside and then not have the upside so we continued to hold our sub debt despite the fact that it wasnt in our index and just traded some government guaranteed bonds versus our existing triple-A exposure.
Gower, Rabobank: From a liquidity standpoint for us the concern was simply that people would prefer a piece of government debt than a piece of Rabobank. That phenomenon changed pretty quickly as investors looked at the underlying institution and decided that government guaranteed bank bonds would sit in their government portfolio.
For us, in many respects people looking for a yield pick-up began to look at Rabobank to fulfil their financial bucket and then just looked to focus on government guaranteed entirely separately.
To all intents and purposes, it presented less of a problem than we thought it would do. 2010, as a result of government guarantees, is actually more of a concern for us purely in terms of the refinancing supply that were going to begin to have, and banks are, depending on where the credit cycle goes, going to really try whenever they can to refinance duration standing on their own two feet. That supply, in our view, notwithstanding the huge cash inflows that are undoubtedly coming in, is going to potentially have an impact on credit spreads.
Whats most concerning, away from the supply, is that there are certain banks and certain institutions that are still going to need need the support, but the stigma attached to it is going to rise sharply.
EUROWEEK:Were you were surprised at the speed of return of the subordinated sector?
Gower, Rabobank: Subordinated historically had been viewed as one very generic little bucket but people have had to become a lot more knowledgeable. Theyve had to because people holding those products realised they were going to get very burnt quickly if they didnt understand what they were holding, and by the same token, allocating cash into that sector.
Once we thought people had a generic understanding of what these structures looked like and what the risk inherent in the various jurisdictions and various levels of support actually was, once that happened in line with government involvement, regulatory clarity on what the recapitalisation of support of the system was going to look like, then it was pretty clear which structures, which issuers, and which jurisdictions would represent value.
When we saw that beginning to happen in February and March, then obviously the lag between the intentions of the US government, the intentions of the European regulators became clear, the equity market then of course followed in February/March which was one of the reasons we looked to do our recapitalisation in the US and the exchange of the first tier one issue. It was very clear that this market was massively undervalued in certain places and we thought people would look to recapitalise.
In hindsight, we paid 11% on a tier one deal and today that looks absolutely ridiculous. At the time people were wondering whether anybody could recapitalise sub-20%. But to your point, we werent surprised at the speed of the return but we were surprised at the speed of return of investors into the lower credit quality institutions.
Rees, Legal & General: I havent been that surprised because you could see the development of it was similar to what you were doing, it became a badge of honour for some institutions to be able to show they could tap the market across all types of capital. Then once youve got the best quality issues opening the market then the second tier or just below the premier league banks come along and then they raise it partly as a badge of honour.
And then with the lower tier banks coming along I was quite surprised that some people were willing to put any money into one of the Landesbank deals that came along. There were a few, but there havent been that many very weak issues raising capital, so investors have been relatively well behaved.
Gower, Rabobank: Its definitely true of the institutional side. One of the things that did surprise us was on the retail side, particularly in Asia where retail institutions became more educated to the nature of these products. One of the reasons we never went into the Asian retail targeted markets was because we did not get the feeling that Asian retail generally had a grasp of the risk inherent in some of these structures.
Trigalou, Insight Investment: Something to talk a bit more about is the debt buy-back and exchanges. That was certainly the main catalyst for the rally in the sub debt market. Then it became a game in certain parts of the market just to buy any sub debt in the hope institutions who issued them would announce a buy-back. Funny games also took place more recently around the Lloyds Cocos exchange. But it is astonishing the way buy-backs evolved: I remember one of the first exchanges was Lloyds upper tier two into tier one, but this route was completely abandoned, because the new bonds did not perform at all; it was just before the March dip I think, and it collapsed some 50 points. After that episode, exchanges became more commonly junior paper into more senior paper. It just transformed completely the market, and to speak frankly, it was a get-out-of-jail card in relation to certain names, so that was an amazing development in the market.
Chunilal, The Capital Securities Fund: The magnitude of return certainly surprised us. We felt very positive, we felt sentiment was too negative, we thought that the market wasnt valuing these instruments on a fundamental basis. Once government support was there, we felt these instruments were going to offer an equity-like return, with the downside protected for systemically critical institutions given the role of government support. I was just surprised by how quickly it went.
It was interesting, because we saw the way these instruments trade change. Before this whole debacle, everyone traded these instruments on the relative credit basis, and was one getting 50bp or 75bp or 100bp above the Libor benchmark, depending on perceived credit quality. No one really focused on instrument structure; no one really focused on language; no one really focused on how an instrument worked in the context of the overall banks capital structure; and an awful lot of learning had to be done in a very short period of time as you had to see which bonds were vulnerable to deferral, which bonds could in theory absorb losses on a going concern basis, and which ones could not.
I still think at this point the market isnt valuing these instruments appropriately. Some banks have simple capital structures within the tiers, others do not. And I still dont think the markets focused enough on this. So, this gives rise for opportunities going into 2010, but we are coming from a much tighter spread level, and I would not have expected things to have rallied quite as much as they did despite being positioned for a sharp market improvement.
Jones, Rathbones: If you look historically at the spread movement, you tend to find back through time that you get big blips and then literally the year after you get quite an aggressive rally. So, from a historic, technical perspective, you would have expected quite a significant rally.
Also, liquidity itself drove the rally, because brokers had such flat books, and some investors were short these issues that everybody wanted to get their hands on, which meant the prices jumped. Another thing was break-even duration. If you think the break-even duration was significant at the longer end, and some of these names had got completely hammered, that any spread widening would not have been an issue. The carry would have still protected you as long as the company was still a going concern.
Going forward there are some still interesting, valuable assets in the financial space despite the rally over the last six months.
EUROWEEK: Before the credit crisis, Rabobank had made big efforts to present itself as an agency proxy hadnt it?
Gower, Rabobank: Very much so we thought from a risk perspective it was appropriate. We thought from a diversification perspective for triple-A portfolios, it was triple-A plus a bit of a yield, and I think people had done fairly well on it.
Of course, when the crisis really kicked in, the pendulum swung entirely the other way, and we were very much a Dutch co-operative bank that had limited access to equity.
But around January time I think people realised that that the pendulum had swung too far the other way, and credit portfolios, which had always disregarded the bank from yield perspective suddenly became interested in the minimal credit risk we presented and the 150bp yield we offered. So, the pre-eminence of the hedge fund was, all of a sudden, back again. But these hedge funds werent flipping bonds they were saying, actually, lets have this as a core holding for six months, we think this will be okay and we can take a punt on something else. The investor base did change, and I think a lot of people had ridden that credit rally, certainly in our name over the past six months
Recently, weve had a lot of interesting calls from people saying they really didnt know us before the crisis and that theyve enjoyed investing in us but now that our spreads have improved will no longer be buying our bonds.
But still, historically, for ourselves, if you look at our credit curve, its pretty wide on a historical basis, we would hope that there remains a lot of interest in our credit going forward, especially in the US.
EUROWEEK: Even if the basis swap goes against you?
Gower, Rabobank: Very much so. Purely in credit terms and risk terms we still offer some value relative to their domestic banks, and I think the education process weve undergone there has been quite dramatic.
EUROWEEK: Lots of nice internal US flights over the next year then?
Gower, Rabobank: Yes, we did put somebody on the ground specifically to do that. Its been quite a challenge although in the US at least from the high grade perspective, unlike in Europe, weve always found the approach to be much more simplistic. Its been very much Fannie and Freddie, and thats about it. Theres been no real credit differentiation in the higher grade space thats beginning to happen now.
EUROWEEK: Did you have to change your approach last year in any way?
Gower, Rabobank: Yes, there was initially at the beginning of the year such a huge proportion of credit investors wanting to look at the name that the nature of the questioning changed. Its a very much more systematic, almost rating agency style balance sheet credit business analysis that investors are doing.
EUROWEEK: Investors were you were putting in bigger orders last year?
Rees, Legal & General: Yes, we were due to inflows into private client accounts. Also part of the result of the big inflows in the sector last year was that, by their very nature, some sterling funds in particular had become huge and therefore by that consequence individual ticket size grew a lot, which also meant that some funds were forced to diversify more outside of sterling as the sterling market was just not big enough to take the flow. But definitely ticket sizes have gone up a lot.
EUROWEEK: What would you have done differently last year?
Jones, Rathbones: Been even more aggressive, if anything. In early 2007 we made a call that there would be a pretty serious crisis in the States, although not as bad as what happened, but we made the call. And I have been quoted as saying that we felt there would be an impact from an impending US housing market problem on CNBC. As a result of that I took 10% out of my triple-B weighting. In hindsight it was not enough. We had the right view but we didnt have the full conviction on execution. So early last year we made a call on tier one and bought it aggressively. But at the end of the day were real money; were not a hedge fund, and perhaps Damien, whos perhaps more leveraged, would be able to put more into that kind of execution.
Chunilal, The Capital Securities Fund: We really got interested in the sector in February/March, which was fortunate with hindsight. However, we were too negative on the US and the whole creditor rights situation. We worried too much about that. With hindsight, the dated trust preferred sector performed very, very well, as you would have expected had you focused on the structures given they are typically dated cumulative securities and ranked above the government preferred. But we got too nervous on the institutional set up there.
Secondly, in Europe there were some situations in weaker names where we thought that buybacks must have been occurring because the secondary market prices had moved so quickly. And then we saw, several weeks after we had reduced our exposure, that there were actually buybacks then announced and that caused a further rally in some securities that we didnt fully participate in. But overall, in terms of macro exposure, we got it right and we made the right macro call. Tactically there probably could have been one or two situations we could have monetised more fully.
Yvernault, Schroders: It was the same thing for a lot of investors they sold too aggressively too late and then failed to buyback aggressively enough in a proactive way as well. But its something we went through back in 2003, so weve been more aggressive than we were then, because its one thing to avoid quite a lot of the landmines during the crisis but then you cant afford to be shy when you are reinvesting in a beaten up asset class otherwise you may also suffer adverse consequences.
EUROWEEK: How do you see the next 12 months playing out in terms of capitalisation and liquidity?
Gower, Rabobank: Theres obviously been a huge amount of comment on that, particularly over the last month with Basel II and CEBS and the like. So the regulatory side is one topic. Of course the other side is purely markets and how we think they are going to fare.
We are quite concerned about 2010 from a credit perspective. I think the regulatory developments at the end of December only add to that concern. Theres going to be a huge, huge drag on bank earnings and to the viability of a lot of retail and commercial banks, certainly in Europe over the next 12, 18, 24 months.
The amount of regulatory liquidity these banks are going to have to carry is going to be very, very difficult, purely from a profitability perspective. From a capitalisation standpoint, return on equity is simply going to be much lower, that, on the equity side, banking as an industry is simply going to be less attractive and there will be a lot of banks which will have to have internal strategic discussions about what their business lines should look like. Theres going to be a lot of M&A, theres going to be a lot of banks that simply decide this it is not worth it; its time to either sell themselves or wrap it up. And from a credit standpoint a lot of that is going to be driven by the ability to access markets at pricing levels which make commercial sense.
So we are quite concerned about that, certainly in the second half as central banks take away their liquidity support. The chances are its all going to happen at the same time when everybody suddenly realises they have to go to market and buy hundreds of billions of government bonds they didnt have before and the ECBs going to take away liquidity at the same time and theres going to be another Greece that hits the screens on the same day.
In the first quarter there will be a little bit of a feel good factor from 2009 purely because of the new cash. We believe that the general marketplace will be positive or receptive for the first period, but from a borrowers perspective Im pretty happy with the liquidity weve raised over the past 12-18 months, because being forced to look at the next 12 to raise significant amounts of liquidity and capital, both from a pricing perspective and an availability of liquidity perspective, would be very difficult.
Jones, Rathbones: I agree with you but also I think theres still a couple of other points as well: tax, which is going to be increasingly going up, both for the individual and for the corporate. These are all things scaring people away from investing in credit.
And so what weve been doing is starting to shorten our book, both from a credit perspective and from a government macro duration perspective.
One of the interesting trades for 2010, and getting it right I think is probably key, is when you switch from fixed to floating.
Clearly, if youre in fixed now youre getting a huge amount of credit, youre getting a huge amount of spread, but being able to make that call is an interesting thing. Weve already seen Libor bottom and its been rising very marginally.
Gower, Rabobank: But that goes head to head with what I think the banks are going to realise what they have to do, which is to extend duration massively in the liability profile. And as the vast majority of banks suddenly realise what they have got to do which is 10 year borrowing and refinance government debt, you know whats going to happen. Thats going to be exactly the point when everyone says, no, we want short paper. And that is going to create a huge potential impact on spreads.
Chunilal, The Capital Securities Fund: For senior funding there are clearly issues, Michael, as youve said, and also, potentially, in a rising interest rate environment, questions. But for tier one I still feel quite positive about it. What other instrument out there gives you an eight, nine, 10% or even more per annum return that is contractually there and that is available for many, many years? I dont know of any. Equities, we dont know, and for what time period can you make an assumption for? High yield I think is very expensive on a relative value basis. Corporate bonds, the same.
With tier one, and I keep coming back to this point, for systemically critical institutions you have the benefit of systemic support, which is absolutely solid. So I still feel positive on tier one although we may see a more adverse senior funding environment that could give rise to further compression of yields between the tier one instruments and senior funding. One has to be more selective, look at this on a name by name basis now and focus very much on structure as well.
The final thing is, from the regulatory perspective, Basle 3. This is focusing on what capital really should be rather than what it has been for the last 15 years. But in that context, I think the technicals for the existing capital instruments are very positive, once we get more clarity about what is going to be grandfathered and what is not and what form of capital instrument is going to count as tier one and what is not.
The supply and demand dynamics for the existing instruments could be very, very positive. These instruments could become antiques over time. I like to own a lot of the rare things and I think thats what these instruments could become.
Jones, Rathbones: But just going back, the point Im trying to make though is that when youve got Crédit Agricole on a tier one yield of about 6% or 7%, Im talking from a whole yield perspective, you only need Gilt yields to rise 1% in a 10 year duration and that completely wipes out your spread for the year. The point that Im trying to make is its a trade opportunity. Its not a long term investment to invest in floating versus the fixed rate tier one at these yield differentials, but I just think theres going to be an opportunity at some point, in the next 12-18 months, where you can switch out of fixed into floating and make some decent returns versus benchmarks and then protect yourself from losses from the rising yields.
Yvernault, Schroders: Well, in Schroders we are quite constructive about the market for a number of reasons. First of all, on the technical front, the flows of additional money to enter the asset class in the first half is massive and extremely supportive of the asset class. Some tourists might consider taking profit on their credit allocation but pretty much every other asset class has also already rallied in 2009. I can see a long pipeline of people waiting to enter. They have all been waiting for a softening in the third or fourth quarter but unfortunately nothing really materialised.
Obviously were entering 2010 from a tighter level than the over-extended level we had in February or March 2009 and thats something we have to consider. The average spread level of the tier one sector isnt going to compress by another 600bp-800bp as we have witnessed last year although I will not be surprised if it is still compresses by 200bp, which is more than we can expect from many other parts of the credit markets.
EUROWEEK: Which products in particular?
Yvernault, Schroders: Late in the year, we shifted a lot of our exposure to bonds which are still trading in the 150bp-400bp area as opposed to the 60bp-150bp area. We are still trying to exploit more cyclical opportunities at this stage.
As always, Schroders Credit Group will rely heavily on its internal credit research in 2010. The difference is going to be able to differentiate true outperformers from the rest of the pack, which have just rallied on sentiment. But what the financial industry in particular is great at is reinventing itself. Too many strategists are worried that new regulation will kill the spirit of the banking industry itself. However, the banking industry has never been short of reinventing itself after each crisis.
The big question for this year is whether central banks can afford to tighten rates. I dont believe that interest rates are going up in a hurry. We still need to be extremely considerate while we are lending out our client monies and we will focus on only select companies which are clearly fundamentally robust.
Jones, Rathbones: So do you not believe that rating agencies are going to act, and if they do, what impact would it likely have on Gilt yields, despite the fact that monetary policy might still be at very low levels?
Yvernault, Schroders: Well, they could easily be fairly range-bound for an extended period of time. If anything, its possible that government intervention is still here to stay for a long while. Its not necessarily the case that everything will be stopped and set in stone forever.
As we know, plans have already been extended. For example, we know that the ECB assistance for the covered bond market will be wound up mid-year but theres no firm commitment it will never happen again.
Michael Gower, Rabobank: The key thing that may save the UKs bacon is that the liquidity regulations in the UK are much tighter than they are in the rest of Europe because the UK central bank doesnt allow covered bonds. Its pretty clear on what it accepts as a liquid asset. In Europe they accept a huge, broad sway.
The European banks are still in denial to some degree, and knowing that the ECB will support them. While in the UK youre going to have a lot of pushing and pulling between a huge bill demand from the banks as they transition out on to the liquidity regulations versus, yes, big fund mega challenges from the UK because of the amount of Gilt financing theyve got. I agree with you; I cant see Gilt yields going down from where they are. I can see them rising, though not cataclysmically.
EUROWEEK: There have been recent reports that European banks will need Eu450bn of capital over the next two years. Is that level of supply a worry in itself?
Gower, Rabobank: It is, although there are two sides to the coin. From an issuers perspective, if you need to recapitalise now you are going to be fighting with a lot of supply. But to Damiens point earlier on, I think there is still a huge amount of upside and demand for the tier one product generally because people are going to have to be prepared to look at new issue premiums in order to get their deals away. And frankly, theres no choice anymore when treasurers look at these deals. Its not a question of, well, can we tighten another five? Its, look, get the money in. Lets worry about improving margins on the retail businesses elsewhere.
EUROWEEK: How important was the creation of contingent capital that Lloyds came up with towards the end of last year?
Jones, Rathbones: For some of our investors its been a bit of a Godsend to be honest. Some of their Lloyds/HBOS paper in the depths of the crisis was trading at about 10 pence. For example the Lloyds 6.0884 perpetual call 2015.
Gower, Rabobank: For some I think it was a get-out-of-jail-free card.
Jones, Rathbones: Yes, but what concerns me is, now, is that obviously theyre trading back up at 80 pence in the pound, about 10%, 11% yields. Okay, youre coupon is secured, but there is this death spiral thing at the bottom if the tier one capital goes below 5%. The other point is how do you actually mark that? They only report every six months. Okay, its been a Godsend but Im still a little bit nervous about what happens when/if everything goes pear-shaped again.
EUROWEEK: But would a government like the UK actually allow Lloyds to go down to anywhere near 5% in the first place?
Jones, Rathbones: I cant see any reason why it wouldnt.
Rees, Legal & General: Thats the reason why theyve created it. Admittedly its a form of capital that might not work because you might get a liquidity death spiral first, rather than the capital one. But one of the suggestions Ive suggested to the FSA is they should put in a liquidity ratio in as well as a capital ratio to the trigger.
Trigalou, Insight Investment: The 5% trigger point is interesting. What if the new bank regulation imposes 6% core tier one as a minimum, or even 8% as we hear in some corners of the market? That would make the Cocos redundant.
EUROWEEK: We saw it being adopted by Yorkshire and Chelsea. Does that show that it has a future beyond distressed issuers?
Yvernault, Schroders: The regulator is very much on board and the British Banking Association is too. The rating agencies have been called in unusual because they are still convertible bonds and the rating agencies have never rated convertible bonds.
But its been quite an interesting product only we had no model on how to value the instrument for our clients. We have no long term database of what tier one ratios have done over time. But in our mind they could be attractive compared to equity and the downside is roughly the same as investing in equities directly.
Chunilal, The Capital Securities Fund: From a regulatory perspective capital should be permanent, non-cumulative and should absorb losses on a going concern basis. Contingent capital sort of does that once youve hit the 5% trigger. We thought the Lloyds deal was attractive at the time. We thought the market would value it, wrongly in my view, as lower tier two plus a spread. And with this liquidity that were seeing coming into this whole asset class, that seemed to be what happened, plus the relief that non-payment, which was a real risk on many of the existing tier one instruments, wouldnt be an issue after one had exchanged into this instrument.
But I do think the concept is potentially flawed given the potential dilution at the worst possible moment, which I think impacts confidence.
I am also concerned about pricing. When issuers started doing the stock settled deals back in the early 1990s, they gave away the stock settlement feature without really thinking about its consequences or whether they were being paid enough to do this.
This time I think investors may not be valuing the equity contingency properly and this may harm them in the future. So, I worry about it from a longer term perspective. I also think there are better ways of creating instruments which are loss absorbing and a going concern. The instruments I have always liked are the participating debt instruments that weve seen issued by German banks and by Swedish banks. No one ever talks about these, but these have principal amounts that can be written down should the need arise.
Rees, Legal & General: It depends on the regulator, because the UK and the US regulators care about core tier one and therefore are focusing on it and are doing stress tests because their banks are more stressed.
So therefore you will probably see more US and UK issues of contingent capital coming out. I dont know whether youll see that many in continental Europe. It depends on the regulator country by country. Ive spoken to some French banks and the French regulator doesnt really care about core tier one at all, so why should they nudge some of their banks to issue? I dont think they will.
With regards to what type of securities will fit, the German style does make a lot more sense and its what CEBS envisioned tier one would be. One of the reason why its not being pushed is because its not tax deductable for the banks, so the origination teams arent pushing it maybe as aggressively as they would others. And also the fees on CoCos are quite nice for the banks as well.
Trigalou, Insight Investment: There is clearly a wide gap between what the regulators want to achieve and what the investors require. There seems to be too many issues attached to CoCos for them to bridge that gap.
EUROWEEK: Michael, have you had discussions about CoCos?
Gower, Rabobank: Yes. Weve said quite publicly that we think when the Lloyds deal was first talked about this was not going to be the panacea for banks that perhaps people hoped it would be certainly the investment bankers hoped it would be and maybe to a certain extent the regulators hoped it would be.
Their thinking was very much influenced by a small group of people who had to get Lloyds, somehow, out of this situation. And frankly we view this as a very neat way of doing it, but we dont think it was a generic comment about contingent capital. We very much looked at it as a Lloyds-specific product.
But whether investors fully understood what they were buying into, again was a repeated question for us. Were always a bit concerned by the nature of who we are and what we do and we believe retail may well be burned. How can they price this? Is it really lower tier two plus a spread? Even your educated retail investor couldve got this seriously wrong.
And in terms of triggers and if you look at what it would take for Lloyds to breach the core tier one trigger of 5%, its going to be a loss of around £18bn. Its not really that farfetched, is it, given what weve been through? So we think that the likelihood of that happening, an expectation of breaching that trigger, is less of a farfetched event than I think its been marketed at.
Have we looked at it from the perspective of is it additive for Rabobank? Yes we have but I dont think weve reached any conclusions yet. Its been very much marketed as a product which is for a bank in stress. We are not a bank in stress, but that said, were always looking to improve our capital structure relative to the pack.
It is reminiscent of hybrid markets back in the early 1990s. Its that type of innovation, that type of uncertainty. Well look at it closely. I think the market will as a whole, but I dont think the Lloyds model is necessarily the model for the rest of the European system.
Rees, Legal & General: You need a product that fits in a debt portfolio, because the problem the regulators in the UK didnt understand was the depth of feeling of benchmarked investors had against this type of product. And youve seen that with the flick-flacking of one of the benchmark providers of whether theyre in or out, of the conflicting pressure between the investors and the intermediaries. And you dont get any size or volume if its not a benchmark product.
Chunilal, The Capital Securities Fund: I also fear that the pricing is such that we are going to set ourselves up for trouble over time with these instruments.
Gower, Rabobank: Yes, as has happened with some of the mispriced hybrids over the past period of time when people dont necessarily understand the risk that they are buying and they think they have an option which is hugely out of money but in fact theyve provided an almost free option back to the issuer in terms of capital on its balance sheet.
EUROWEEK: Obviously a huge amount of short term debt has been issued over the last year or so. As investors, do you think issuers will be able to meet their needs for longer debt?
Rees, Legal & General: As long as the inflows carry on into the fixed income market then they will be fine. But if there is a withdrawal of cash away from the fixed income market then it could be challenging. I still think its possible. The other thing is that not many banks are growing assets at all in fact there is a 0%-5% reduction of balance sheets which is quite large numbers when you calculate across the whole European banking system so therefore the refinancing requirement is actually slightly smaller than you think it might be.
However, it could be a challenge, especially if everyone tries to frontload at the first quarter.
Trigalou, Insight Investment: I absolutely agree that the deleveraging component is often left out of the equation.
EUROWEEK: But is the investor community prepared to take the credit risk? Because of course people are going to be doing this on an unsupported basis.
Rees, Legal & General: Well, so far they have. People quite happily bought Irish and Greek bank senior debt, which is an interesting decision. Probably between those two countries, they probably issued Eu5bn-Eu10bn of senior unsecured, unguaranteed debt which is now five to 10 points under water, but they managed to issue last year.
Gower, Rabobank: But theres going to be a lot of low single-A and triple-B banks that have to borrow tens of billions in 2010.
Rees, Legal & General: Those will be challenging. Yes, I agree.
Gower, Rabobank: But those are the things which are likely to cause market disruption, arent they?
Rees, Legal & General: Im not sure to the extent to which some of the smaller banks will carry on relying on the ECB, so youre still going to see the bigger issuers, maybe to the mid-tier, who will do lots of refinancing. And the smaller issuers, I think, have got big problems.
Chunilal, The Capital Securities Fund: The other question is how much equity needs to have to be raised. Because if innovative tier one is banned going forward and if things like deferred tax assets dont qualify as core tier one and if pension fund deficits get deducted from core tier one this will have a big impact on how much and in what form new capital will need to be raised. And were not really sure in what form the new forms of capital can really be raised aside from common equity. So theres going to be a lot of equity supply, which again comes back to an earlier point I made. You look at tier one versus common and I know which one Id rather have.
EUROWEEK: What do we have to look forward to in 2010?
Gower, Rabobank: Products will develop and there will certainly be opportunity for investors both in terms of spreads and structures, to put money into products which offer value.
From our perspective well certainly continue to provide products to the street. Whether or not we need the liquidity, we think were duty bound as a higher rated bank to be overly liquid in these times and from a capitalisation perspective the same holds true.
But there is certainly optimism, but with heightened awareness over extraneous events such as a Greece or a Dubai, which can cause a temporary wobble and make people sit up and take notice.
The Outlook for Bank Finance in 2010
The financial institutions sector was the hardest hit of all the major bond markets in 2009 following the collapse of Lehman Brothers and the ensuing financial crisis. For the first few months of 2009 only the best or bravest came to market without government guarantees. Rabobank was one such institution, launching a Eu5bn deal in the first weeks of the year that garnered an impressive book size of nearly Eu7bn. It paid for its success though, paying 150bp over for the five year deal. However, the Dutch co-operative proved that the markets were still functioning and, perhaps more importantly, that it had access to liquidity even in those darkest of days. Thankfully for all concerned in the financial institutions sector, as the year progressed, conditions eased and deals began to flow. Piece by piece, the FIG jigsaw began to take shape, with hybrid capital and regulation-driven deals to the fore in the second half of the year. By the end of 2009, issuers, investors and bankers were feeling increasingly confident that the coming year would be easier to navigate and operate in. In this inaugural roundtable on bank finance, sponsored by Rabobank, some of the leading FIG market participants discuss how the market is continuing to recover, which products and geographies will fare better than others, the impact of contingent capital bonds and whether or not that product will taken up by other issuers across continental Europe and beyond, and how the market will cope with the vast amounts of short term debt due to be refinanced this year as well as the large amount of additional capital financial institutions will need to meet regulatory requirements.
Participants in this discussion, which took place in December 2009 in London, were: