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Hunger for yield may be the panacea for lower tier banks

hungry iceland crab

The turning macro cycle means smaller bank issuers can afford to take their time and steer clear of the seemingly piping hot but unpredictable bond market

It may go against the grain of conventional thinking, but lower tier European banks can — and should — wait to finalise funding this year. On this occasion, rushing into a crowded market in an attempt to try and woo investors' attention is not the sole winning tactic.

Typical syndicate desk mantra implies that it is better to issue sooner than later. And no doubt, current market conditions are ripe for less frequent financial institutions to advance their annual funding needs.

But while pulling the trigger now certainly has its merits, and is usually the preferred approach for many bank issuers, the risks it brings are not insignificant. Lower tier and less frequent bank issuers will have to vie for investors’ attention, and buyers prefer better-known credits. These are often not only more familiar names, but tend to be bigger banks that are more profitable because of their diversified business operations. Arguments that would certainly make it easier for investors' credit committees to approve a prospective investment.

This is not a new phenomenon and there is a tried and tested solution. Lower tier borrowers can attract demand by offering higher credit spread and yield than comparable debt from major banks. This way, investors will be compensated for various factors related to less liquid deals from these smaller issuers.

But these higher spreads — that they are already paying anyway in the current market where investors clamour for yield — is precisely what these borrowers can use in their advantage as they seek to better time their transactions.

The turning cycle

The market backdrop has changed. The position of many fixed income strategies is now that major central banks are very close to the end of their tightening cycles through interest rate increases.

Whether the Fed or the European Central Bank increase rates once or twice more from here, the overarching market expectation is that the end of rate rising is in sight. Indeed, many bond investors have started to position for this in far bigger segments of the fixed income markets than just esoteric FIG deals from smaller issuers. Long end supranational, government and agency bonds, and corporate hybrids, are back on the menu.

This macro backdrop can prove beneficial to a smaller bank looking to fund. Rather than needlessly delaying a deal in an empty hope that spreads will grind tighter, or rushing into the market at all costs, it can now much better time each transaction to ensure the greatest results.

Last week’s strong FIG issuance in euros offered plenty of higher yielding deals, and Monday and Tuesday of this week have also been productive days for such smaller borrowers. All these trades ended with very strong uptake from investors, allowing lower tier and infrequent issuers such Banco de Sabadell, BPER Banca, Cajamar or Landsbankinn to substantially tighten their senior deals from their initial guidance.

For smaller and infrequent issuers of this ilk, even issuing senior debt in this higher interest rate environment is not a cheap endevaour. Icelandic lenders — like Landsbankinn — know this well, despite ranking among the most well capitalised banks in Europe.

Still, the Reykjavík based outfit had to offer a yield of 6.5% for a €300m 3.5 year senior preferred bond this Tuesday. On top of the deal carrying a green label, it was also accompanied by a tender offer of an existing €300m trade due next year. The buyback suggests that some investors could have switched from the old to the new bond, making the yield on offer so much sweeter for buyers.

But not so much for the issuer.

In an environment where peak inflation may be in sight with the end of the tightening cycle, or so current investor sentiment suggests, smaller bank issuers' deals will be in higher demand precisely because of the juicer yield they offer to national champions. As investors eye higher yielding paper, these bonds’ scarcity element coupled with the higher yield should prove enticing for those that can buy these credits.

Even if spreads are to somewhat widen from here it should not deter issuers much. A 10bp or a 25bp widening of credit spreads will cost issuers extra funding, but as a percentage of their total funding cost this is just a fraction of what they will pay anyway, even in a market so conducive for issuance.

But if an issuer ends up going head to head with a European national champion or if investors decide to focus their attention on any given day into any other direction, a deal's outcome could quickly become very uncertain. This will risk the funding altogether. Whereas a mild spread widening is unlikely to do so if the overall market remains relatively open for issuance. In fact, that extra yield from the widening would only sweeten the investment proposition as the expected peak rate rising cycle approaches.

Instead, biding their time allows such issuers the opportunity to devise a careful battle plan that avoids a direct fight with Europe’s national champions. This time, the macro backdrop will be lending them a helping hand.