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Calm before the storm: LTRO roll-off bodes well for FIG supply

01 Oct 2012

Negative net supply, volatile markets, unattractive rates and cheap central bank liquidity — for large portions of 2012, the bank finance market has been an unhappy place. But towards the end of the third quarter, capital issuance was finally going ahead, even without the official green light from European regulators. Forthcoming LTRO redemptions make a torrent of supply likely in 2014 and 2015. Will Caiger-Smith looks ahead to a busy future in the FIG market.

Redemptions have far outstripped issuance in the financial institutions funding markets over 2012, as banks shrink their balance sheets and consequently require less funding. And even though funding markets have sprung back into life after the summer, net supply is still expected to be negative in 2013.

"The pressure on issuers is now less important on the funding side," says Philippe Hombert, global head of FIG and SSA DCM at Natixis. "Issuers have access to very easy cheap funds, with support schemes, and their funding needs are decreasing because of the deleveraging and their limited new production. Nevertheless they will continue to come back to the market, even if for some of them it is just to prove they have access."

And as the funding taken down by banks in the European Central Bank’s longer term refinancing operations (LTRO) in December 2011 and March 2012 comes due, banks will once more be forced into the market.

Despite regulatory pressure on banks to fund longer, data collated by Lloyds shows that the average duration of issuance has gone down since 2005, from 7.4 years to 5.7.

Issuance has been concentrated in the two, three and five year space, with those tenors accounting for 57% of prints. Nevertheless, the average maturity has increased between 2011 and 2012. Lloyds puts this down to the LTRO effect, combined with a lack of supply from peripheral issuers.

Banks took down over €1tr of three year funding in the two LTROs. They can pay the cash back before the three years are up, but the majority of it is expected to be redeemed in December 2014 and March 2015 — signalling the biggest year for redemptions market participants can remember.

According to Lloyds’ data, redemptions are set to jump from just over €60bn in 2013 to around €1.08tr in 2014 and over €1.2tr in 2015.

The LTRO bought banks breathing space to get their balance sheets in order, but even in a healthy market, that is one big refinancing cliff. Simon Adamson, senior credit analyst at CreditSights, believes another intervention may be needed.

"It will be a matter of seeing what condition the market is in and whether banks can find funding elsewhere," he says. "It’s not a long term solution, it’s just given the banks some space to sort themselves out. I would say it’s less likely there will be another LTRO in the near term but it’s possible that when the facilities mature we might need another form of refinancing."

Safe as houses

The meteoric rise of the covered bond market over the past two years is also expected to continue. The product has consistently offered a safety net for issuers to fall back on when the senior market closes or becomes prohibitively expensive. Continued uncertainty around bail-in and resolution regimes means the asset class will likely enjoy a good year in 2013.

Natixis calculates that €930bn-worth of covered bonds — including privately placed and self-led deals — will come due in 2013. Syndicated covered bond redemptions come to €161bn.

"Issuance in senior unsecured will represent a bigger share than covered bonds," says Thibaut Cuilliere, head of credit strategy and deputy head of credit research at Natixis. "This year the spilt was 47/53 between senior and covered, but in previous years it was 60/40. The result of the crisis has been to decrease senior unsecured compared to covered bonds. In view of the encumbrance ratio and the tightening of spreads, we expect issuers to concentrate on senior unsecured deals."

The debate over balance sheet encumbrance has quietened down over recent months, but many market participants are still worried that an over-reliance on covered bonds could be harmful. A recent divergence in spreads between the two asset classes could help remedy the situation, says Rob Ellison, head of FIG DCM at UBS.

"One problem with pre-crisis funding models was that there was not enough term funding in the system," he argues. "Senior offers term funding, and banks cannot live by covered bonds alone. What is healthy is that the covered and senior investor bases are moving apart again. This time last year we saw covered and senior buyers buying covered bonds, but given where rates and spreads are, there is not enough return in covered bonds so people who had moved from senior to covered are moving back."

Capital cushions

The lower tier two capital market, which appears newly revived after a spate of deals in early September, will be crucial for FIG issuers, many of which will be keen to insert a comfortable buffer between senior investors and buyers of more deeply subordinated capital instruments before bail-in arrives in 2018.

"Capital issuance makes a lot of sense, especially because bail-in will be on issuers’ minds," says Karim Mezani, head of FIG syndicate at Natixis. "If you want to protect senior holders, lower tier two is important. There is appetite for it now, and the market for those transactions will be more active until the end of the year and in the first half of 2013. So long as the sovereign crisis is not back on the screens every three months, that could happen, but we need to get that cleared before we have a regular issuance pipeline."

Given the uncertainty around the regulatory treatment of tier two under the Capital Requirements Regulation I (CRR I) and the Capital Requirements Directive IV (CRD IV), a backlog of tier two issuance has built up. Under Basel III, a 2% bucket of total liabilities must be filled either by expensive common equity or cheaper tier two.

SEB, which printed a €750m 10 year non-call five deal in September, said the deal would help fill its 2% bucket, which was almost empty. Other banks are in similar situations, having been unable to access the market.

One capital specialist estimates that European banks will issue around €50bn of tier two debt over the next 12 months. Mezani at Natixis, meanwhile, believes that if current conditions prevail, the market could even see issuance from peripheral borrowers.

"It’s interesting what has happened in the lower tier two space since the beginning of the year," he says. "We started off with strong Scandinavian, core European names, and now Raiffeisen Bank International is coming to market. For a large portion of the year, core country issuers were predominant in senior, but now that market is back open for peripherals. It might be some way off, but could lower tier two open up for peripheral countries? The signals are good — when the market is bullish, people are keen to buy anything, peripheral or not."

Meanwhile, depending on how quickly issuers get clarity from European regulators on what will be accepted as tier one capital, bankers predict that market could be just as busy. And investors are ready and waiting.

"Investors are hungry for yield, so the market definitely has the capacity," says Gerald Podobnik, co-head of capital solutions Europe at Deutsche Bank. "Investors have done a lot of homework to get themselves acquainted with these structures. They have put in the hours understanding the different structural risks involved, getting their heads around non-viability, and write-down risk or conversion risk in tier one. And a lot of groundwork has been done in terms of changing mandates so they can invest in something that converts to equity or is written down. There has also been a lot of internal education for the portfolio managers, so they should be ready for this new generation of securities."

Obstacles to issuance

Whether or not these investors will get the supply they are looking for all depends on the regulator, however.

Issuance of tier one and tier two capital has been stymied by uncertainty over what will qualify under CRR I and CRD IV. In tier two, one of the main sticking points is how — and indeed whether — to incorporate point of non-viability (PONV) language into bond documentation.

The Crisis Management Directive allows national regulators to force losses on capital holders when a bank is deemed to be non-viable, and asks for this to be noted in new tier two deals. In the absence of comprehensive details from European authorities on how this should be done, however, national regulators for the moment seem happy to sign off deals that mention PONV either in the risk factors or in the terms and conditions.

Questions remain around the eligibility of the latest wave of tier two issuance. But as more banks second guess the regulatory trialogue — the discussion between the European Commission, the European Council and the European Parliament — the pressure is mounting for it to be accepted. If regulators were to turn around at the last minute and impose a radically different template for loss-absorbing tier two capital, the fallout could be severe.

"The more tier two paper that comes to market — if it comes from a reasonably diverse range of jurisdictions and all has the same structure — the higher the likelihood that it will be accepted politically," says Christoffer Mollenbach, head of European FIG DCM at Lloyds. "We feel confident that these structures will be accepted under the new regime, and if they are not, they will be grandfathered."

The Asian dollar market is set to be a hotspot for tier two issuance in 2013. UBS, ABN Amro, ANZ and Westpac have all recently issued Reg S deals into Asia, getting a high level of participation from private bank investors. And while many European institutional investors are less receptive to the asset class, executing a deal in Asia affords issuers a level of security they may not find elsewhere.

"The Asian market for capital has capacity," says Ben Nielsen, head of European syndicate and DCM at Nomura. "It’s not a blanket open book, and it only works for certain issuers, but the depth is far greater than in Europe right now. It’s challenging to do a euro-denominated institutional deal. That is changing, and the market is looking forward to that. But issuers need a high certainty of execution, and that means dollars, marketed towards Asia."

Many issues need to be resolved before the markets can return to stability but it suddenly appears that there is hope for FIG issuers. Issuance is gaining momentum, and depending on how the situation on the continent plays out, 2013 could well be a much happier year than 2012.
01 Oct 2012