Last week UBS brought the preferred senior asset class into the negative yield club when it sold €2bn of new bonds from its operating company at 13bp over three month Euribor.
Granted, the notes will mature in just two years. But it was a sign of the times for the preferred senior bond market, which has done nothing but grind tighter since the beginning of the year.
The rally first started when investors came to expect that supply would dry up in the asset class. Indeed, many banks have been busy replacing their maturing senior bonds with new forms of debt that comply with the terms of various regulatory standards, including the Financial Stability Board’s total loss-absorbing capacity (TLAC) rules and Europe’s minimum requirement for own funds and eligible liabilities (MREL).
But some banks would do well sticking with the old format for as long as possible.
As they start to lose access to cheap loans from central banks — a guaranteed funding line that has barely needed thinking about over the past few years — financial institutions are going to want maintain at least some form of access to the cheapest forms of debt the wholesale funding markets can offer.
GlobalCapital has written before about the threat that the preferred senior asset class could pose towards covered bonds in this climate, especially as the European Central Bank starts to wind down its asset purchase programmes, as well as its cheap lending programmes.
But the potential battle between two asset classes has only come into sharper focus in recent weeks, as preferred senior bonds have started to trade closer to their covered bond counterparts than ever before in many jurisdictions.
If you were then to think about the fact that some preferred senior bonds could have value from a regulatory capital perspective, as well as a funding perspective, the case for continuing to issue them starts to become even more compelling.
Bail-in is sometimes considered in quite rigid terms — some assets can be bailed-in, other cannot. But really the concept is more freely flowing. In theory, resolution authorities can impose losses on anything they can slap a value on, including preferred senior bonds.
And regulators recognise this in their capital standards.
Under the final TLAC rules, for example, banks can use up to 2.5% of their risk-weighted assets as preferred senior debt in their 2019 ratios, rising to 3.5% by 2022. That only applies if a resolution authority can, by law, exempt any TLAC-excluded liabilities like insured deposits and certain derivatives from bail-in. Debt ranking pari passu with those liabilities may then be included in a bank's ratios up to the stated amounts.
In certain jurisdictions this would no longer be possible. When spelling out their proposals for MREL, taking into account the TLAC standard, the Bank of England and Swedish authorities both said that they wanted banks to meet a subordination requirement for any eligible liabilities.
But other banks could take advantage of the carve-out for preferred senior debt, depending on how MREL applied in their jurisdictions. Clearly, this would give asset class an extra edge.
Analysts at the independent research provider CreditSights have compiled data showing how close they think banks would be to hitting their MREL targets in 2022, if the banks were able to include 3.5% of preferred senior debt and if they were not.
UniCredit, for example, would have a €34.2bn shortfall if it couldn’t use preferred senior debt, according to the data. But it would have a €21.9bn shortfall if preferred senior bonds were included for MREL purposes. For BNP Paribas it is the difference between a €67.2bn shortfall and a €44.6bn shortfall.
A number of European banks have been a little unclear in saying whether or not they will carry on issuing in the asset class, or switch out completely into more subordinated forms of senior debt — Lloyds and Crédit Agricole being two notable exceptions.
One syndicate head wondered whether that might be a sensible move, as telling investors to expect supply from your bank in both preferred and non-preferred senior could mean that you end up missing out on the so-called “scarcity premium” in one or the other debt class.
But putting public communications aside, bank management teams should recognise that there is potentially a lot of value in maintaining a regular, if slower, flow of supply in preferred senior.
At a time when capital requirements are high and net interest margins are low, there are plenty of reasons why preferred senior could well start growing into its name.