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Crisis puts sub debt to the test

By Frank Jackman
17 Dec 2020

European banks passed a real-life stress test in 2020 as the coronavirus pandemic threatened to topple the economy. The experience has improved the standing of subordinated debt, which is becoming more important for issuers and investors alike. Frank Jackman reports.

Bank subordinated bonds went through a rollercoaster ride in 2020.

A global pandemic has put the instruments through their first system-wide stress since the 2008 financial crisis, when the asset class was reimagined as a new layer of contingent capital on the balance sheet.

Spreads on additional tier ones (AT1s) reached as high as 1,600bp as the coronavirus took hold in March, amid fears that the bonds might do what they were designed to do and suffer losses.

But yields then quickly came back down to earth, with investors realising that the products were better protected than they might have imagined.

“It is safe to say this is a different type of crisis, and not one that stems from the banks,” says Isaac Alonso, head of FIG debt capital markets at UniCredit in Munich.

“Banks are now part of the solution — and it’s a fair assessment to say that the industry went into turbulent conditions better capitalised than 12 years ago.”

Common equity tier one (CET1) levels sat at an average of 14.9% of risk-weighted assets going into 2020 — a record high for the euro area.

Review 2020Regulators have since stepped in to try and bring even more confidence into the banking sector, given that it is expected to play a critical role in keeping credit flowing into the real economy.

The European Central Bank has relaxed certain capital buffer requirements, for example. It has also strong-armed institutions into turning off their shareholder distributions, increasing the size of the equity cushion protecting the subordinated bondholders below.

“The responses from governments, central banks and regulators led to an improved market backdrop,” says Mark Geller, head of FIG debt capital markets, EMEA at Barclays in London.

“Common equity tier one ratios in Europe have generally increased over 2020 due to regulatory forbearance and the impact of capital retention in the form of dividend and buyback prohibition.”

The result is that confidence has coming flooding back into the subordinated debt market.

Heading into 2021, AT1 yields are once again hurtling towards all-time lows. The iTraxx European subordinated financials index stood at 108bp at the beginning of December, less than a third of the spread it offered in the middle of March.

Pillar of strength

If market participants wanted any further evidence of the strength of subordinated debt during the pandemic, rule makers have even moved to put the asset class at the centre of their response to the crisis.

In March, the European Central Bank fast-tracked a rule that would ease the burden of complying with individualised Pillar 2 capital requirements (P2R). Under the new guidance — which had originally been slated to come into force in January 2021 — banks can satisfy P2R with AT1s and tier two debt, rather than having to meet their demands with CET1 capital only.

“This was a very good decision as it allowed issuers to move forward with their capital management,” says Gabriel Levy, Natixis’ global head of debt capital markets, corporate and investment banking in Paris.

The changes to P2R have led to a mini boom in issuance. 

Review 2020Whereas banks had previously only been able to issue subordinated debt to meet their basic Pillar 1 requirements, now they can come forward with deals that contribute towards their Pillar 2 targets as well.

As of December 7, banks had issued €17.3bn worth of AT1s, a rise from the €7.98bn issued at the same point last year, according to data from UniCredit.

“Despite the coronavirus pandemic, bank capital issuance has remained undeterred as borrowers had ratios and forthcoming total loss-absorbing capacity (TLAC) and minimum requirement for own funds and eligible liabilities (MREL) requirements to meet,” says Alonso.

Although the changes to regulatory capital buckets have created headroom for issuance this year, sales of these instruments are unlikely to soar again in 2021.

“Given that many banks have already optimised their capital structures, we believe the focus for 2021 will be on refinancing redemptions — as opposed to the optimisation of P2R requirements,” says Alonso.

The supply of subordinated paper is expected to fall from €37bn in 2020 to €32bn in 2021, according to ING Research — comprising €19bn of tier two and €18bn of AT1.

This will feed into a broader trend of banks reducing their reliance on capital markets during the coronavirus pandemic.

“On the secured side, central bank facilities such as the Targeted Longer Term Refinancing Operations (TLTRO III) in Europe took care of some of the base funding requirements that banks had,” says Geller.

Size doesn’t matter

A lack of supply is expected to create even more demand for new deals next year, as investors scramble to try and put their cash to good use.

Central banks have slashed their main interest rates in response to the coronavirus crisis.

The US Federal Reserve made the most dramatic action in March, when it cut its target range from 1%-1.25% to 0%-0.25%. Many of the world’s major central banks now either have policy rates sitting below zero, or just above it.

In this kind of an environment, subordinated bank debt offers a rare source of yield for credit investors.

Analysts at Morgan Stanley remain overweight on AT1s going into the new year, despite the strong performance of the asset class in 2020.

They see the instruments as attractive compared with similarly rated corporate bonds, while also benefiting from a better fundamental credit strength.

“Central bank rate cuts helped to stimulate the demand for yieldier products,” says Geller. “We saw investors gravitate towards sub debt and AT1 instruments once the market had stabilised.”

Even smaller financial institutions, which typically have less access to the market, have been brought into the fold.

“Less frequent issuers are often sought after given their rarity, while the propensity to invest in those credits with more complex stories has also grown in this environment as a result of the move in overall yields and the search for enhanced returns on the investor side,” Geller says.

These dynamics have been in full view during the early winter of 2020, which has presented smaller lenders with a golden window of opportunity.

In November, 13 of the 24 new public bank deals issued in euros were below €500m in size, according to data from Dealogic.

Ordinarily, sub-benchmark offerings are low-key affairs. But smaller transactions are proving increasing popular with investors, which are having to work harder to get their hands on new paper.

Triple-B rated Mediobanca, for instance, attracted a peak order book of €2.7bn from over 200 accounts for its €250m 10 year non-call five tier two in mid-November.

“What helps these names is the sheer liquidity afforded by investors and the demand for higher beta products in a low-yield environment,” says Alonso. “If the deal is well prepared and the credit story right, then these names can tap the market with the smallest of transactions.”

Risks on the horizon

Nobody is kidding themselves that the European banking sector is risk-free going into 2021, however. The strength of bank balance sheets is to some extent underpinned by new and extraordinary support measures.

European governments have offered to guarantee lending, for example, and borrowers have benefited from payment holiday schemes — both of which are temporary arrangements.

“It will be interesting to see how the anticipated economic elasticity and rebound in 2021 impacts banks with the prospect of increased credit demand such as rising mortgage volumes having a subsequent effect on banks funding needs in the market,” says Geller.

Smaller lenders could be among the most exposed to any economic fallout, given a lack of diversification in their revenue streams.

Levy says the crisis will “weaken the capital structure of smaller institutions, and therefore could drive more M&A operations. In turn, this could be an opportunity for some banks to develop themselves and drive concentration.”

But the uncertain economic outlook could also impact the way in which larger financial institutions choose to manage their capital.

Some issuers have already shown that they are willing to put their own economic interest ahead of those of their credit investors.

Several banks passed on AT1 call options to call outstanding AT1s during a volatile trading period at the height of the first wave of the coronavirus pandemic, for example.

Deutsche Bank led the way when it became only the second financial institution — after Santander in 2019 — to extend the life of one of its AT1 securities.

The German lender said in March that it would not call its $1.25bn 6.25% AT1 on its April call date, thereby leaving the bond to reset to a spread of 435.8bp of five year US Treasuries.

Fund managers are likely to try and be more selective as subordinated bond yields move back towards record lows, despite the pressure to carry on picking up paper.

They will be conscious that the rollercoaster ride is not over yet, with new twists and turns still ahead lying ahead in the coming year.  GC

By Frank Jackman
17 Dec 2020