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FIGBank Capital

Tier two's American future?

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Tighter trading levels for bank tier two in the dollar market could shed light on the future of the equivalent market in Europe. Stand by for spread tightening.

In the past few years, trends in FIG primary markets have often rolled from west to east. They have started in the United States with the nation’s big banks, before crossing the Atlantic, spreading across Europe and perhaps drifting on through Asia.

That has certainly been the case with using call options to optimise the capital eligibility of senior bonds, as the big US firms began piling into the format towards the end of last year before it took off with holding company issuers in Europe.

And it may therefore be wise to look to the US for clues about the future of the tier two market in euros.

At present dollar tier two spreads are an average of 60bp tighter their euro equivalents, which is something that BNP Paribas exploited this week when choosing to grab $1.5bn in the format rather than attending to its needs in the newly-created “non-preferred” senior market.

According to one FIG source, the difference in valuations is mainly a function of how investors look at the chances of losing money.

When looking at the big domestic banks, the buy-side in the US has typically thought of tier two bonds as being fairly well cushioned by a firm’s common equity and preference shares.

By the same token, if losses at a financial institution are bad enough to take out tier two then they would also surely hit senior debt at the holding company level — the next asset class in line for losses in US bank capital structures.

But in Europe this logic is not reflected in secondary spreads, where non-preferred senior bonds look like much safer investments, as they trade at very expensive levels versus their tier two equivalents.

According to analysts at BNP Paribas, for example, euro-denominated non-preferred senior bonds trade in a range of 54%-69% of tier two spreads, while in the dollar market the equivalent senior bonds trade in a range of 58% and 95% of tier two spreads.

Bankia’s recent blowout tier two should not be taken as a sign that demand for the asset class is rising, even though investors ploughed into the trade and were willing to take a spread that was some 40bp tighter than initial price thoughts.

That’s because recent tier two deals have mainly been brought to market by smaller and less frequent issuers — making buying the bonds much more of a comment on the specific name in the market and the likelihood of further supply, rather than their relative place in the capital stack.

The broader US market can't yet serve as an example for all of Europe, because there are still so many capital issues at some many European banks. But as the larger issuers build up their levels of loss-absorbency through issuing additional tier one, and their common equity tier one ratios creep higher, the cushion below tier two will start to look increasingly American, while a fixation on building a non-preferred senior bond market will limit new tier two supply.

So BNP Paribas's trade in dollars should be seen as a sign of things to come — and secondary tier two should grind tighter.

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