Opportunities for exercises may have reduced in the last 12 months as FIG bond prices have staged a remarkable rally, but the pattern of trades proves that liability management is not a cyclical tool, and banks have quickly moved from repairing their balance sheets to optimising them. Tom Porter reports.
It is a dangerous thing to declare that any financial institution has enough capital, but banks seem to be getting there. Despite full implementation of the world’s flagship regulatory framework still being five years away, plenty of banks now proudly display fully loaded Basel III-compliant capital ratios in their earnings presentations.
Many of those banks turned to liability management specialists to bolster their core equity tier one (CET1) numbers, buying back debt at heavily discounted prices through 2011 and 2012. But for regulators picking through the debris of bank balance sheets following the 2008 financial crisis, increasing capital levels was not enough. Banks were also instructed to improve the quality of the capital they did have.
And judging by the level of activity in the LM space this year, they are clearly still somewhere between the two.
“I would describe 2013 thus far as a transitional year in terms of banks’ motivation for using liability management exercises,” says John Cavanagh, head of DCM products and liability management at Bank of America Merrill Lynch.
“The market is moving from a period where many transactions were being done to urgently fortify capital levels to one where we are starting to see a greater focus on opportunistic balance sheet optimisation, given the more benign and supportive market environment.”
In the first eight months of 2013, €31bn of paper had been repurchased or exchanged by banks through 37 LM exercises. That compares to €60bn from 82 trades for the same period in 2012 (trades from European financial institutions in any currency, and non-Europeans in euros).
Out of the woods?
This lull in activity is symptomatic of a banking system that has largely finished with its urgent dash for CET1. As fears over the long term stability of the system have eased, the appeal of that type of trade has also faded as FIG debt prices have recovered.
“Capital accretive transactions will continue where opportunities present themselves,” says Andrew Burton, head of liability management at Credit Suisse.
“Obviously the trades have become smaller and less beneficial to the issuer because prices have come back up and are now, in many cases, above par. LM in the FIG space is settling into the kind of activity that exists in other sectors, where it is a tool for making improvements to a capital markets strategy focused on primary issuance.”
And it is not just the trades that haven’t been done that reflect the improved outlook. Two of the top 10 deals by volume so far this year have been buybacks of government guaranteed bonds. One of those was ING Bank, which retired a third of its total GG debt in July, paying above par for €2bn of securities issued in 2009. That was war funding, and this is peacetime.
But there are still opportunities out there to grab a little extra CET1, particularly for those banks not as far along the road to recovery. National Bank of Greece booked a capital gain of around $155m in June after offering investors a 50% discount to face value for $560m of preference shares, achieving a participation rate of 50%. That followed similar capital grabs from Piraeus Bank and Alpha Bank.
Retire and replace
The next big trend will be capital enhancement. LM desks have been predicting a pick-up in this sort of exercise for some time, but banks have so far been held back by a lack of clarity from regulators on what new instruments they need to replace old.
That could all change on the first day of 2014, when the European Union’s Capital Requirements Directive (CRD IV) is due to be finalised. Banks are impatient for a line to be drawn under the new capital rules; in July the European Banking Authority announced via an online Q&A session that non-called legacy tier one securities would not, as the market had expected, be eligible as tier two going forward.
“Regulation remains the biggest driver of LM transactions at the moment, and we expect subordinated debt to dominate going forward,” says Aziza Breteau, head of FIG origination for France, Belgium and Switzerland at Natixis. “The finalisation of CRD IV and the acceleration of the leverage ratio will be huge drivers in that regard. Banks will have to issue new subordinated debt more rapidly than they had anticipated, due particularly to the leverage ratio, and that should lead to more buybacks of legacy sub debt.”
Some banks have already started that process, and for many LM specialists a tier two exchange from Intesa Sanpaolo in September perfectly represented the immediate future of their market.
The Italian bank issued a new €1.45bn tier two bond on September 6 after buying back €1.428bn of outstanding tier two debt, in an effort to optimise its capital structure and replace old-style capital with new paper that will be fully recognised under the CRR.
“The Intesa trade is symptomatic of where the market is going and not where it has been,” says Credit Suisse’s Burton, who worked on the trade. “The issuer came out to proactively manage its capital structure and did an LM transaction that efficiently satisfied their twin goals of retiring old and issuing new subordinated debt. They came to market with a strong proposition and the opportunity for €5bn of their existing investors to participate in the new issue.”
Exchange and upgrade
Royal Bank of Scotland more than doubled the cap on its buyback of 11 capital securities issued by RBS NV — launched as a complement to a $1bn new subordinated Yankee issue in June — eventually retiring some $2.5bn of old-style bonds. Barclays also bought back $850m of subordinated paper alongside its $1bn contingent capital transaction in April, and this exchange approach should prove increasingly popular next year.
“Rising cash prices for existing capital instruments have made CET1 generative trades less attractive but also have driven new issue levels to increasingly attractive levels,” says Cavanagh.
“That situation creates a natural progression from cash-funded deeply discounted buybacks to buybacks either funded by attractively priced new issues or enhanced by an LM transaction where the tender or exchange is used to create a beneficial demand circle to facilitate investor participation in the trade.”
The tactic may well lead to more favourable terms for investors. Banks will want to leave a good impression when tendering for old-style capital in order to sell new bonds back into the same investor base.
Under less pressure to boost capital levels, banks have been able to turn their attention back to making money in the last 12 months. Many, particularly in the US, have turned in strong quarterly results in 2013, and credit analysts have shown an increasing interest in net interest margins (NIMs). The problem for banks in general is that NIMs are not where they would like them to be, suppressed in recent months by a lack of market volatility and the persistent low interest rate environment.
However, banks in general are also sitting on a big pile of cash as a result of balance sheet deleveraging and fuelled by central bank liquidity. Many have decided to put that money to good use by retiring big chunks of senior unsecured debt that their business models no longer justify. The four biggest LM trades so far this year, and six of the top seven, have targeted senior debt as lenders have called in the LM specialists in search of one-off profit gains.
“Balance sheet size reductions has been one of the main drivers of recent senior unsecured buybacks,” says Cavanagh. “Many institutions are flush with cash, and the return on that cash can be negligible given where cash deposit rates have been. If a financial institution has a choice between earning somewhere near Libor on a cash deposit and going out and buying back one of their own bonds at a better yield, then that is a wise investment which has a quantifiable impact on their bottom line.”
UBS holds the top spot in euros, and its €4bn buyback of 14 senior bonds in February was a perfect example of this trend. The Swiss bank said its restructuring announced last October — which included a swathe of redundancies and the scaling back of areas of its fixed income business — had left it with reduced funding needs, enabling the tender offers.
Bank of America, meanwhile, will be tough to beat this year when US dollar activity is taken into account, after taking some $5bn of euro, Canadian and US dollar senior off the market in August. The US bank had printed a €1.5bn seven year senior unsecured deal on July 18, partly to offer investors being targeted in the exercise an opportunity to move into new paper. Citigroup’s LM team has also been particularly busy putting excess cash to work in the past 12 months or so, and has now retired around $25bn of senior, subordinated, preferred and trust preferred securities since the start of 2012.
Despite the obvious drop in activity this year, the LM technique is in rude health and growing in popularity with both issuers and investors. When banks return to market with more certainty on capital rules next year, they can be confident they are dealing with bondholders that better understand their motivations.
“In the past, liability management was seen as very defensive, but now banks see it as an integral part of the toolkit they have at their disposal to improve liquidity or capital, which was not necessarily the case two years ago,” says Romain Brive, director, global structured credit and solutions at Natixis.
“We now see many issuers doing two buybacks on the same bonds without much time in between and achieving decent participation rates on both occasions. Investors understand that the regulatory environment is changing very rapidly and issuers can take opportunities without having the same stigma attached to them.”