Sub debt finds a new following

  • 14 Mar 2002
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Gentlemen prefer corporate bonds, but marry sub debt. Or at least that is what the spread performance of bank capital over the past two years tells us. While investors' love affair with the new corporate market has proved a stormy relationship, subordinated debt has been much more dependable, so much so that demand for eligible issuers is now outstripping supply. Philip Moore reports on the dynamics driving the market.

Who'd be a banker? Or an insurer, come to that. M&A activity has collapsed, equity analysts are warning investors to steer clear of the sector, and global recession is spawning a mountain of non-performing loans. As a result, bad debt provisions have been skyrocketing -- by more than 50% at Royal Bank of Scotland (RBS), more than 40% at Barclays and by just under 40% at Lloyds. And that's just in the UK, which is viewed as one of the tighter ships of the European banking industry.

Does the subordinated debt market worry much about any of this? Apparently, not a bit. Take the most extreme recent example of a bank coming under sudden and wholly unpredicted stress -- the occasion on which the senior managers of one bank arrived at their desks in Dublin one morning to be told that a trader sitting some 6,000 miles away had spent the last five years drilling a $750m hole in their balance sheet. Naturally, spreads on Allied Irish Bank's (AIB) tier one paper bonds responded to the news, but not half as much as may have been expected from what, at first glance, was potentially Barings all over again. Indeed, many investors clearly saw the initial widening of 50bp or so as providing a buying opportunity, judging by the speed with which the spreads narrowed back in when the dust had settled.

With some investors speculating that the debacle had thrown AIB into play, and with many viewing RBS as a likely predator, by the end of February its tier one paper was trading only about 20bp wider than when news of the currency losses first broke.

A much broader illustration of the resilience of the market for subordinated bank debt came in the aftermath of September 11. As SG noted in its review of developments in the credit market in 2001: "On the demand side, cash-rich investors seem reluctant to part with their subordinated bank paper despite substantial gains, given the scarcity of investments offering a decent yield with stable credit fundamentals. It was noticeable that after September 11, there was not a wave of selling and excessive spread widening (compared to that of the corporate sector) of subordinated debt as was the case during the emerging market crisis of 1998."

Far from producing selling pressure in the bank capital market, the global political turmoil arising from September's atrocities allowed financial institutions to spearhead new issuance in the immediate aftermath, helped in no small measure by upgrades for issuers such as Barclays and RBS in the UK. RBS, for example, was quick to capitalise on its upgrade from Aa2 to Aa1 by Moody's in October by increasing an outstanding Eu1bn lower tier two transaction by Eu500m via Morgan Stanley -- a deal that was seen by many as providing some welcome safe haven territory.

Strong demand for stability coupled with yield helped subordinated bank debt to emerge as one of the most rewarding asset classes in 2001. According to Barclays Capital: "Most importantly, investors in bank debt and capital instruments were among the happy few to have avoided major credit blow-outs and achieved total returns of 7.4% for senior debt and 13.8% for tier one instruments."

Scorching demand

There are myriad reasons explaining why demand for subordinated bank debt has become so strong over the last 12-18 months. Most obviously, against the backdrop of a low interest environment, bank debt in general and subordinated paper in particular provides one of the lowest risk options for investors desperate to lock in some extra yield.

After all, in a world perceived to be populated by highly volatile and unpredictable credits, banks have suddenly presented themselves as oases of stability. "As an asset class, banks are popular because unlike much of the corporate sector they are regulated, which tends to provide a floor as to how low their credit ratings can fall," says Damian Chunilal, global head of financial institutions at Merrill Lynch in London.

"At the same time, retail banking in particular is viewed as a safe, solid business with reasonable margins, and banks are generally seen as relatively high RoE institutions. From a ratings perspective the overall bank credit story has been pretty good, especially in comparison with some of the industrial sectors."

That credit story, say bankers, is perceived to be growing stronger, in marked contrast to sectors such as telecoms. "What investors and analysts have generally come to believe is that the ability of banks to manage their credit exposure risk is significantly better now than it was when we had the last downturn in the credit cycle in the early 1990s," says Alan Patterson, managing director at Citigroup/SSSB in London.

"The main risk to the good run we're now enjoying in the subordinated debt market would be if the banks' half year numbers provided evidence that this improved risk management turns out to be a fiction -- but I don't believe that will happen."

Others share Patterson's confidence. "One reason spreads are so tight in the subordinated market is clearly a function of dwindling supply," says Andrew Readinger, managing director and co-head of the financial institutions group (FIG) at Morgan Stanley in London.

"But investors also seem to believe that the economic cycle is not going to get significantly worse, dramatically impairing the quality of banks' portfolios and forcing them to write down loans and therefore write down capital. Banks are entering this downturn with the capital they need to survive it, and they are typically high single-A or double-A institutions that are committed to maintaining those ratings. Especially in light of Basel II, they need those ratings to maintain attractive wholesale funding costs and to stay in business as creditworthy counterparties. That's not the case in the corporate sector. How long ago was it that everybody thought the double-A ratings of the major telecoms companies were sacrosanct?"

That perception of stability is now outweighing any concerns that investors may have about the theoretical risks to holders of subordinated securities -- which ought to be substantial. After all, the assumption that needs to be made is that in the event of a bank liquidation the recovery rate in senior debt would be in the order of 30%-50%, with tier one capital wiped out altogether. In practice, however, investors appear to be assuming that this simply would not happen -- at least, not to those banks that have issued in the public subordinated debt market.

In part, that reflects a belief that there would ultimately be political support for any leading deposit-taking bank finding itself in trouble. As one banker puts it: "The banks are much closer to the political voting power of the man on the street than any large corporate is. If a large corporate goes bust people get thrown on the dole. But if a high street bank in the UK were to go bust, you'd be talking about 25% of the country's depositors being affected, and they would have something to say about it." In other words, there is an unwritten "too-big-to-fail" element of protection for investors in the upper echelons of the banking industry.

Historical evidence seems to support the notion that investors in subordinated paper are far more strongly protected than the letter of the law would suggest. "The fact is that we have had no examples so far of an operating bank defaulting on any of its subordinated debt in Europe," says Ian Centis, analyst at BNP Paribas in London. "Although some subordinated debt holders in the Barings holding company lost money, even at the height of the banking crisis in Scandinavia subordinated debt continued to be honoured. And in France, although Crédit Lyonnais stopped paying dividends on its ordinary shares at the height of its problems it did not defer anything on its hybrid issues."

This leads to the question of why it is that investors can earn triple-digit basis point pick-ups for subordinated paper relative to senior debt, and whether or not that pick-up is too high. The answer, of course, is that the subordination element itself is only one of several factors written into the premium that issuers need to pay in the bank capital market.

"If you look at the subordination premium built into the structure, it would seem that investors are being over-compensated for the risks they are taking," says Chunilal at Merrill Lynch. "I wouldn't say that investors don't care about subordination, but I think the principal risks they are taking in the market are maturity and extension risks. In some of these structures the real risk is that bonds won't be called when investors think they will be, and I'm not sure that that is being factored into pricing sufficiently. If it were, investors should probably buy some of the older outstanding transactions in which they have more protection because the step-ups are higher."

Pricing in risk

Part of the spread between senior and subordinated paper is also accounted for by liquidity or perceived liquidity risk. Although liquidity across most classes of subordinated debt has improved immeasurably in recent years, the market is inevitably less liquid than its senior counterpart and will stay that way. "One of the reasons why the market for tier one debt is less liquid than we may have hoped is that there are so many different regulatory frameworks across Europe that make the product look very different from market to market," says Henry Nevstad, head of MTNs at Dresdner Kleinwort Wasserstein (DrKW) in London.

"Because you're not really comparing apples with apples in the tier one market, Europe is made up of lots of small markets rather than one much larger and homogeneous one."

But that has not prevented the size of the investor base for hybrid securities from changing beyond recognition in recent years. "I remember when I was running our syndicate business in Germany and we led a number of lower tier two Deutschmark deals for banks such as Citicorp, Lloyds and RBS," says Rob Jolliffe, head of FIG in debt capital markets at Goldman Sachs in London.

"Then, the number of buyers of subordinated lower tier two deals was far more limited, hampering distribution in large volume. Today, lower tier two is largely a commoditised product that most investors are happy to buy. The investor base for tier one is probably not as deep, but I would guess that 80% or 85% of those investors that buy lower tier two are now also buying tier one. So in the space of three or four years we've moved from a lower tier two market that hardly existed to one that is now almost universal, and we've come nearly as far in the tier one sector."

The extent to which the institutional investor base had broadened over the last few years is also self-evident, says Jolliffe, in the typical size of the subordinated transactions that have been rolled out in the last 12-18 months compared with those Deutschmark denominated curtain raisers. Transactions such as those for RBS (DM500m), Citicorp (DM400m) and even the DM750m raised for Lloyds seem tiny now relative to the jumbo issues of 2000 and 2001 that regularly raised Eu1bn and more.

Institutions in, retail out

The growing strength of the institutional bid has more than compensated for the withdrawal from the market in some pockets of continental Europe of the retail investor base that provided a bedrock of demand for bank capital instruments for much of 2000 and 2001. That demand was especially strong in the Iberian peninsula, where individuals turned to hybrid instruments as ersatz bank deposits with or without understanding the risks involved, and many had their fingers badly burned. Elsewhere in Europe, however, bankers say that retail demand for subordinated product remains strong in regions such as Benelux.

"There is some retail demand in Benelux," says one banker, "but there must be a limit to demand there. If you add up how much has been done by issuers like ABN Amro, ING, KBC, Fortis and Aegon, it probably comes to one preferred security for every citizen in the Benelux region. That means retail demand in Benelux is probably reaching saturation point and will remain open only on an extremely name specific basis for Benelux-based issuers. Where does that leave us in terms of pan-European retail demand? Nowhere."

So the only remaining large reservoir of retail demand for subordinated bank debt would seem to be the US market, which remains problematic for European issuers because of SEC registration requirements. Bankers hope that will change when in 2004 or 2005 the SEC moves to accepting accounts based on International Accounting Standards.

For the time being, reaching retail investors -- either in Europe or the US -- is unlikely to be a priority for bank issuers while the institutional bid for subordinated debt remains as sizeable and durable as it is today. But it is not just the size of the institutional investor base that has broadened and stabilised demand. Bankers say that institutions bidding for bank capital are using much more sharply honed credit analysis skills than as recently as two years ago.

As evidence supporting this, they point to the difference in the spread performance from credit to credit. At Citigroup/SSSB, Patterson says that there is no herd instinct among investors in pricing the subordinated market. "The market is clearly differentiating between different credit stories," he says. "If you look at the Spanish banks, for example, BBVA and BSCH have lagged behind their international peer group, which is obviously a reflection of their exposure to Latin America. At the same time, those Spanish banks with a domestic orientation are outperforming in both the senior and the subordinated markets. Investors are looking much more closely at the stability of the regional franchises and if anything they are now pricing these banks through the leading international players."

Aside from becoming better at credit analysis, investors in the European market are also showing far more understanding of the technicalities of subordination. "I don't think it's just a case of looking at the credit," says Andrew Slaughter, head of bank capital and FRN trading at DrKW in London. "It's also a question of looking at the structure. No two tier one deals are the same, structurally. Some are issued at the holding company level and some at the bank level. Some are dated and others aren't."

One example of relative value analysis across different structures is comparing direct issuance securities -- spearheaded by the Reserve Capital Instruments (RCI) designed by Barclays Capital -- with those issued via special purpose vehicles (SPVs). At Merrill Lynch in London, Chunilal insists that investors are now well versed in appraising the various merits of each instrument. "The RCI structure may seem intuitively simpler," he says. "But I think investors now recognise that, from a credit perspective, given that the SPV issuer will in almost all cases be guaranteed on a tier one basis by the parent bank, it frankly makes very little difference whether an issue is launched directly or via an SVP. Is one better than the other? No. Is one valued differently by the market place? No. Direct issuance deals used to trade about 5bp tighter than SPV issues, but that differential has now largely disappeared."

Improved analytical capabilities, both of credits and structures, has had an important impact on relative pricing in the bank debt market. "The most interesting aspect of the market is that when we started to work on the first subordinated deals in Deutschmarks, the pricing spread between senior and lower tier two debt was typically in the region of 45bp-50bp," says Jolliffe at Goldman Sachs. "That spread has narrowed very considerably."

An important byproduct of this development, adds Jolliffe, is that it is making the European market better placed to compete with the US as a viable and cost-effective source of funding for subordinated debt. He points out that historically the US market was an attractive source of subordinated debt funding for European banks because of the narrowness of the spread differential between senior and lower tier two, typically in the order of 5bp-10bp.

That, he says, reflected the fact that US investors were at that time much better versed in credit analysis than their European counterparts, and once they were comfortable with a given credit they were happy to move down the subordination ladder and buy tier two debt. "I think most European investors have now made that similar leap from senior into subordinated debt," says Jolliffe.

Desperately seeking supply

So much for the good news about appetite for subordinated debt. The bad news is that supply is stubbornly refusing to match the level of demand now being generated among institutions.

"Between 1995 and 2000 supply grew very dramatically," says Merrill Lynch's Chunilal. "In 2001 and 2002 it has fallen off very sharply, although the average issue size has actually risen, demonstrating that the market has become more liquid and more mature. This is particularly evident in the euro and sterling sectors."

That decline in new issuance volume is frustrating for bankers in financial institutions groups, but not, at the moment at least, job threatening. As Chunilal and others point out, even if issuance of subordinated debt has declined over recent months, there is plenty of other work for bankers from their clients in the financial institutions sector. "The focus has moved much more towards the management of capital and assets through securitisation," says Chunilal, "and that is where most of our time and effort is being spent today."

Why is supply lagging behind demand? One reason lies in the depressed state of the M&A market in the European banking sector. "There is a strong correlation between tier one issuance and M&A activity, and it is no coincidence that we saw a very large batch of issuance a year or so ago when there was a lot of domestic consolidation going on in the banking sector," says Centis at BNP Paribas. "Today, with the possible exception of Germany, M&A activity is pretty much dead, with most major markets having taken domestic consolidation about as far as they possibly could."

Border crossing

The next phase in bank consolidation that analysts are now waiting for is therefore the much-heralded cross-border M&A activity that -- bar isolated exceptions such as HSBC's acquisition of CCF -- has remained conspicuous by its absence. However, several analysts believe that among those banks that have not yet fully exploited the opportunities available in the subordinated debt market, some may be waiting for more cross-border opportunities to arise. "A lot of banks are keeping whatever margin they have left on tier one in place in case they need to issue in support of an acquisition," says Centis.

This touches on the second reason explaining the slowdown in supply of subordinated paper: the 15% limit on tier one capital that can qualify as being tax-deductible. Understandably, many banks in Europe have used their relatively new-found freedom to race to this 15% threshold in double quick time, meaning that several are already at or new their limit.

Many of those banks that have not gone close to their 15% limit, meanwhile, are probably those that would not be able to raise cost-effective funding in the subordinated market anyway. "There is a host of weaker banks in Europe that would love to tap the hybrid capital market," says DrKW's Slaughter. "But generally it is not a market that is open to the weaker banks. The investor base in the subordinated debt market is clearly looking for solid double-A credits. Investors might move down to the mid single-A level, but not below it, and the weaker credits have tended to underperform."

Whether or not the 15% limit will be reviewed, potentially prizing open more opportunities for the stronger banks to issue more in the way of tax-deductible tier one, is a subject that is now being debated. In the UK, the Financial Standards Authority (FSA) is working with the British Bankers' Association (BBA) on what bankers describe as a "pre-consultative" phase of debate over the definition of innovative capital that, many believe, will ultimately pave the way for issuance beyond the 15% threshold.

"It does appear that the UK is going to consider structures that will permit tier one hybrid issuance outside the 15% limit," says Chunilal at Merrill Lynch. "Banks in the UK have always been able to go beyond that 15% limit with directly issued preference shares. The trouble with those is that they're not tax efficient, and the Holy Grail is to do transactions outside the 15% limit that are tax efficient. I believe the marketplace is now believing that we will see a modified RCI-type structure that will allow for tier one issuance beyond the 15% basket." If this materialises, he adds, there will probably be an increase in tier one issuance on the one hand, accompanied by increasingly complex ratings considerations on the other, as the ratings agencies assess the optimum level of core tier one capital.

Others agree that the 15% limit could change. "The bottom line is that we believe that both direct and indirect issuance will be permitted for UK issuers outside the 15% bucket as long as these structures don't have cash step-up features," says Ben Katz, head of hybrid capital products at Lehman Brothers in London. "That would be consistent with most European markets, where banks are issuing outside the 15% through SPVs with no cash step-up. In other words the FSA seems to be foreseeing a non-innovative bucket of preference shares-type structures up to 40% of tier one that could be tax-deductible but would not have an incentive to redeem." That is all well and good; the snag is that without step-ups, institutional investors are unlikely to be enthusiastic buyers of the product.

None of this is to suggest that issuance is going to dry up entirely, with bankers expecting new volume to emerge from several pockets. One of these is the German Landesbank sector, which has traditionally not needed to look seriously at the subordinated debt option, given that the guarantees it enjoyed in the form of Anstaltslast and Gewährträgerhaftung covered all classes of its debt. With those guarantees now having a limited shelf life, issues are starting to emerge that offer investors a glimpse of how Landesbanks would look in the post-guarantee world.

Insurers ensure supply

Beyond the straight banking sector, the insurance industry is starting to attract bankers' attention. "Insurance has been an emerging sector over the last two or three years and I think there is probably more to come in terms of issuance from the insurers this year," says Patterson at Citigroup/SSSB. "The insurance industry in general, and particularly the life insurance sector, is becoming much more capital consumptive. At the same time, the asset side of the balance sheet is no longer bailing out the sector's capital requirements because insurance companies are not seeing the same levels of capital gains as they have enjoyed over the last couple of years. The interaction between the asset and liability side is critical, and it is posing an interesting set of questions for banks that own insurance companies."

Transactions from the insurance sector have been very welcome to an investor base starved of supply in the subordinated market, let alone diversification. As an illustration of just how welcome this new issuance is, take the response to the brace of deals from the heavyweights in the UK insurance sector launched late last year.

First off the blocks was CGNU, with a two tranche sterling and euro hybrid capital transaction led by Barclays Capital, Lehman Brothers, Merrill Lynch and SG. This had originally set out to raise a total of £1bn equivalent, but ended up with tranches of £700m and Eu800m, or the equivalent of about £1.2bn. A 100% oversubscription level allowed both tranches to be priced considerably below the originally indicated range, with the sterling bond emerging at 185bp over Gilts (compared with an indicated 190bp) and the euro tranche at 112bp over mid-swaps (as against an indicated 115bp).

CGNU was soon followed into the market by Prudential, which launched its first ever hybrid deal in December via Goldman Sachs and UBS Warburg. This was a dual tranche issue that ultimately raised Eu500m alongside £435m, which again was much larger than had been planned. Demand reached close to Eu1.2bn on the euro book and more than £800m in the sterling deal, allowing for both tranches to be priced well within the guidance levels.

For the time being, bankers reckon that the shortage of supply in the subordinated market will result in spreads remaining tight, or even compressing further. As Slaughter at DrKW points out, spreads in tier one issues barely responded at all to the news that fourth quarter loan loss provisions were rising at banks across Europe. "If more bad information starts to filter into the market people might start to think that tier one is priced a little rich to lower tier two," he says.

"But by the same token, they will be asking themselves whether they really want lower tier two paper at 30bp over Libor when there is tier one available from the same credit at 100bp over." *

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  • 14 Mar 2002

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
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1 Citi 241,977.38 927 8.19%
2 JPMorgan 223,817.40 997 7.58%
3 Bank of America Merrill Lynch 216,160.55 723 7.32%
4 Barclays 185,098.93 672 6.27%
5 Goldman Sachs 158,991.47 518 5.38%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
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1 JPMorgan 32,522.19 61 6.54%
2 BNP Paribas 32,284.10 130 6.49%
3 UniCredit 26,992.47 123 5.43%
4 SG Corporate & Investment Banking 26,569.73 97 5.34%
5 Credit Agricole CIB 23,807.36 111 4.79%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
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1 Goldman Sachs 10,167.68 46 8.81%
2 JPMorgan 9,894.90 42 8.58%
3 Citi 8,202.25 45 7.11%
4 UBS 6,098.17 23 5.29%
5 Credit Suisse 5,236.02 28 4.54%