After Zurich Finance priced a Eu425m 30 year non-call 10 lower tier two last week, it would be tempting to declare the market reopened. With Eu3bn of demand, the Zurich deal showed that there was real depth of appetite for the structure in the euro market. And while that appetite had already been evident in the sterling market with deals from Prudential and Royal Sun Alliance, no issuer had tested it in euros since September. Even before that, the structure had fallen out of favour with investors as fears around extension risk grew.
However, there were many strings attached to the success of the Zurich deal. Firstly, a large part of it — 65% — was sold to UK and Irish investors. While this was partly due to the nature of the pre-sounding process which focused on that region, there is still a question mark over how much demand European fund managers have for the callable structure.
Secondly, it is an insurance transaction. By its nature, then, it offers a higher new issue spread than most bank issuers would offer in lower tier two. And that high new issue spread means a correspondingly high step-up at the call date — in theory high enough that the issuer would call it at the first opportunity. It would be difficult for a bank to replicate this as regulators do not like to see such a strong incentive to call. Yet, this is one of the key elements giving investors comfort that extension risk has been all but eliminated.
But there’s an ever more fundamental reason as to why callable lower tier two issuance is unlikely to make a return. Banks just do not want or need it.
Bank regulators continue to be focused on tier one, and in particular core tier one, capital. The new rule books on bank capital currently being written don’t contain a chapter worth reading on lower tier two — the product barely rates in a mention in the footnotes. It’s seen as an instrument of leverage — and therefore a contributor to the current problems faced by the industry.
Insurance companies, on the other hand, are not under the same constraints. Any capital is good capital and the rating agencies’ equity treatment is almost as attractive as regulatory equity treatment. Lower tier two will, as a result, almost become confined to the insurance sector.
So, while the importance of the Zurich transaction should by no means be diminished, extending the success of the trade to a full reopening of the dated callable market would be a step too far, in a world that has fundamentally changed.