Banks should bite the tier two bullet
As tier two spreads widen, new issuers might find a saving in avoiding a call option
Banks looking to raise callable tier two funding ahead of the summer should reconsider their plans and think about using cheaper bullet strucutures instead.
Of course, syndicated bullet tier two deals are rare in euros. No borrower has sold one yet so far this year, and only three were sold throughout the whole of 2021, including two from insurers, according to GlobalCapital data.
Financial borrowers typically prefer issuing callable tier two debt as it is more efficient from a capital perspective.
When a tier two bond enters the final five years of its life it starts to lose its regulatory value, even if it still count towards the minimum requirement for own funds and eligible liabilities (MREL).
As a result, banks like to structure the bonds with a call five years before maturity to allow for refinancing. This approach is popular; 12 of the 17 tier two bonds sold in euros this year have a duration of five years between their call and maturity dates.
However, those that are willing and able to stomach the cost of amortising tier two capital down the line might find in this difficult — and possibly at times incredibly busy — market that using a bullet maturity will help secure some much welcome execution certainty.
This certainty comes in the solving for uncertainty: the lack of a call option removes the risk that a tier two bond is extended, with investors instead benefitting from a firm redemption date.
Banks will opt to extend their tier two paper if the costs of refinancing do not make sense. Deutsche Pfandbriefbank, for instance, last month opted against refinancing an upcoming call, instead opting to extend the note for a further five years. And bankers believe other borrowers could follow this year.
As a bullet note lowers extension risk, it should remove part of this risk from the price offered to investors — and at a time when execution is difficult, banks need all the help they can get.
The average spread differential between the two formats in Europe is about 60bp, according to research from ING, which accounts for the extension risk within the callable instruments.
With banks set to pay elevated new issue premiums ahead of the summer break, opting for a bullet deal could help a prospective borrower shave basis points of funding costs off an already pricey instrument.
Furthermore, issuers would avoid the risk of these high spreads coming back to haunt them when the elevated levels re-emerge as reset spreads. In a callable tier two structure, if the bond is not called its coupon resets to a spread over a mid-swaps benchmark, in the case of euros this is commonly the five year rate.
For instance, May’s Handelsbanken 11 year non-call six tier two will reset to a spread of 275bp over the five year mid-swap rate. Its last tier two deal, a 10.5 year non-call 5.5 year, sold in August 2018, will set to only 127bp over the rate.
As spreads and yields creep upwards, so too will the possible reset payments. Over the past year, the five year mid-swap rate has climbed over 250bp, rising from minus 28bp to 228bp on Tuesday afternoon.
Of course, a tier two needs a minimum of five years before it can be redeemed or called, meaning that the shortest possible bullet notes starting to lose regulatory eligibility not long after issue.
Issuers might find that it is not worth the cost or time to print a five year bullet note, when paying up for the call option allows them to keep the debt on their balance sheets as tier two debt for at least the same amount of time.
So perhaps if longer dated bullets are too much for issuers to stomach, then they could look towards the example of Zuercher Kantonalbank’s senior non-preferred halfway house tier two from April.
The Swiss bank structured its euro debut as a six year non-call five year, allowing it to remain as going concern capital for a greater part of its lifetime.
But what banks might find that in a market where the shorter the deal, the better — just look at the recent interest in three year non-call two senior bonds — is that eschewing the call option and opting for a bullet note might be as short as they are going to get in the format.