Allure of CoCos widens
European legislation is set to increase demand for hybrid issuance.
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The majority of European banks will be able to sell contingent capital bonds by the end of 2014 as politicians and regulators seek to push through legislation that will create a level playing field for hybrid issuance.
Over the past year, European financials sold some €38bn through Tier 2 and Additional Tier 1 bonds and market experts are expecting that figure to more than double to €80bn–€100bn by year-end.
“CoCo issuance is likely to accelerate in the first half of this year having picked up at the tail-end of last year,” said Simon McGeary, head of new products, EMEA at Citigroup. “It won’t come all at once because there are still some jurisdictions that have to resolve their tax issues but I think by the second half of the year we could be at almost a full run rate.”
At the end of last year, Italian and Dutch banks got a step closer to being able to sell Additional Tier 1 bonds with both governments taking action to make it easier for their banks to sell hybrid instruments. This leaves Germany as one of the final frontiers for the hybrid product.
Under the Basel III framework, banks can raise 1.5% of their 6% Tier 1 capital ratio in the form of non-dilutive equity-like instruments, which can also be used to improve banks’ leverage ratios.
Until December, only banks in the UK and Spain had clarity on whether Additional Tier 1 instruments were tax-deductible, a key aspect for this type of debt as it makes it a lot more cost effective to issue. Italian, German and Dutch banks have held back these types of bonds as they have waited and lobbied for government officials to modify tax rules to make them tax deductible.
“The Dutch are also waiting for clarity but I think by the end of the year most jurisdictions will be able to issue CoCos,”said Antoine Loudenot, head of capital structuring at Societe Generale. “At the moment, I think it’s ambitious to think that Germany’s banks will be able to issue this kind of capital soon.”
Instruments in all three countries are likely to feature a 5.125% Common Equity Tier 1 trigger as is stipulated by the Basel III/CRD IV requirements.
Top banks are likely to have to tempt investors with 6%–8% in annual interest on the bonds, an attractive option in a world of near-zero interest rates. But this is still cheaper than issuing equity, which typically costs around 10%–12%.
Looking at the size of order books on recent deals it is clear that there is ample demand for these products. At the tail end of 2013, Societe Generale, Credit Suisse and Barclays unearthed over US$50bn equivalent worth of orders for Additional Tier 1 bonds, laying to rest any doubts about the strength of the global investor demand for these high risk securities where coupons can also be suspended.
The size and strength of the global investor base for such securities had been one of the greatest sources of concern for European bank treasurers given how much needs to be issued in the coming years.
“The question for the year ahead is will the European market become as deep as the US dollar sector,” said Antoine Loudenot, head of capital structuring at Societe Generale. “I think with the prospect of Fed tapering we may see more than just eurozone investors looking for European bank paper in their home currency.”
According to analysts at JP Morgan, based on a peer group of 25 European banks, total issuance of Additional Tier 1 capital is likely to reach €31bn in 2014 while Citigroup’s analysts have said the overall global market for capital instruments including Additional Tier 1 and Tier 1 could grow to more that US$1trn over the coming years.
“This year is going to be a busy one for bank capital,” said Peter Jurdjevic, head of balance sheet solutions at Barclays. “Certain banks may front load this kind of capital at the beginning of the year and we could see a second wave after the summer.”