DCM 2006 - Eternal flame
European issuers of Tier 1 capital have an array of structures and currencies from which to choose. While the US dollar market found favour until recently, the NAIC’s reclassification of some transactions as common equity and investigation of others has hamstrung the sector for the foreseeable future. Can the euro true perpetual market offer an alternative? Philip Wright investigates.
Turn the clock back to November 2004. Barclays Bank had just launched its €1bn perpetual non-call 10 core Tier 1 deal and talk was of a brave new world emerging. The transaction's most noteworthy aspect was that it included no step-up clause but was sold into the institutional market.
Received wisdom up until that stage had been that the only feasible way in which to raise Tier 1 capital beyond the 15% innovative limit in Europe was to target retail investors, as their demands are not always as stringent as their institutional counterparts. Barclays proved that this was not necessarily the case.
As an issuer, the bank has had a long history of innovation, particularly in the non-innovative, core Tier 1 sector. Its Reserve Capital Instruments (RCI) and Tier One Notes (TONs) both ventured into uncharted territory before falling foul of regulatory rethinks. The volume of transactions seeking to replicate the new format was limited, and because only a handful of deals utilised the non-step-up so-called true perpetual blueprint, casual observers not following the market could be forgiven that something similar had once again happened.
This is not the case, however. The sector remains a possible source of funding for those who wish to investigate it, even though it requires a greater spread because notes are not tax deductible and lack step-up clauses.
"While hybrids are tax deductible, true perps are not so there is an additional cost involved. It is not something you just do unless you really need it," said Barclays Capital's Paul Avery. While an opportunistic step-up Tier 1 is in itself a rare beast, an opportunistic true perpetual is almost guaranteed never to see the light of day.
With no step-up to act as incentive for the borrower to call the bonds, there is greater potential for them to become perpetual instruments, hence the true perpetual name tag. This possibility naturally leads to a greater trading volatility, and this too can influence supply.
When Barclays returned to the euro market for its second transaction at the beginning of March 2005, few were to know that it would hit the top of the market. The €1.4bn issued in the face of more than €5bn of demand also featured a 15-year call date, so had an even higher beta than its initial offering. When the cracks began to show and fear overcame greed as the driving force behind investors' trading decisions, it bore the brunt of the increasingly negative sentiment, dragging the 10-year callable down with it.
Everything likely to work in its favour in a positive market conspired against it in the bear environment: its size and consequent liquidity, the fact that it was still primary and therefore offered a free market play – in the near term at least. In fact, it became a proxy for the entire market and suffered more than other issues. This did little to placate disgruntled investors who were left wondering what they had bought.
As a source close to that deal noted, however, many of those accounts had been involved in the first deal and had harboured no such misgivings when times were good. If they were seeking someone to shoulder responsibility for the falling market, there was an argument that they, as the buyers with the potential to underpin prices, were more culpable than Barclays, whose only transgression had been to launch the transaction just prior to unforeseen market movements. And it was hardly as if they were forced to buy the paper, after all.
As Amir Hoveyda, head of EMEA debt capital markets at Merrill Lynch explained: "People who buy into that sort of instrument have to expect that kind of volatility."
Reputations to uphold
The question of under what circumstances the bonds were sold is key to the whole sector. The FSA, for example, takes the view that to qualify as core, non-innovative Tier 1, not only there should be no incentive to call the issue (as in no step-up clause) but also no indication that this is a likely course of action.
Even though the transactions launched so far have kept strictly to the letter of the law, the general perception is still that the call represents a de facto end date. The most commonly quoted reasoning behind this thinking is reputational risk associated with not calling the paper.
Banks rely heavily on the bond markets and are serial issuers, if they do not cater to investors' needs, they could find funding a trickier proposition. Investors, on the other hand, like to incorporate as much certainty into their investment decisions as possible. While the specific forbidding of any indication as to whether the call option will or will not be exercised would appear to take away that desired certainty, accounts are able to make their minds up – and not just through a leap of faith.
"There is unofficially a fair degree of comfort that the issuer will call the deal," acknowledges Arnaud Achour, head of DCM origination at Societe Generale. This implied result is by necessity purely down to investors making assumptions based largely on the reputational damage associated with a borrower not calling an issue, although other considerations can play an important role in this decision-making process.
Credit Logement, for example, sold €800m of non-step up Tier 1 paper through SG, BNP Paribas and HSBC. With the current 100% risk weighting on its residential loan guarantees set to be reduced with the onset of Basel II in 2010, the likely result is that Logement will be over-capitalised come that date.
With lower requirements, expectations are that unneeded paper will be retired. Add to this that Logement's deal included a call option at year five rather than the 10 or 15-year dates utilised by Barclays and others, and it is clear that certain conclusions can be drawn. While there is no suggestion that this eventuality was promoted during the marketing process, investors are bound to make their own minds up and will have been aware of the situation.
Even if the assumption proves to be misplaced, accounts have the additional spread to fall back on. "Some think that [non step-ups] will definitely be called, some say that with a 40bp-50bp yield pick up it is worth the risk. Fundamentally, if someone likes the credit, they will buy it," said Avery.
Effectively, if the name is acceptable and the market is in buoyant mood, then such instruments are easier to sell.
"It is a real bull market trade," said Anthony Fane, co-head of DCM FIG Europe at BNP Paribas. "You need positive momentum."
Also added to the mix has to be the different investor bases across the currencies. While fund managers in the sterling and US dollar markets have a long history of investing in this kind of instrument, there is not the same breadth of tradition in the euro sector. This manifested itself in the fact that the euro issues have proved more volatile in turbulent times and it is perhaps telling that, in its recent perpetual non-call 10 Tier 1 funding exercise, BNP Paribas chose to stick with a step-up format for its euro tranche, reserving sterling for the true perpetual portion.
With the NAIC reclassification of Lehman's ECAPS transaction as common equity and the subsequent filing of numerous issues hitherto regarded as preferred for consideration by nervous US insurers having put the US dollar market on hold, issuers that might otherwise have regarded the US as their first port of call will now be forced to reconsider. This will thrust the sterling and euro markets into the limelight.
"There will be increasing attempts to push some flow to euros and sterling," said Merrill's Hoveyda. "Whether those markets will have the capacity, we'll see."
While this could have the effect of creating a more mature market in the Eurozone, there are bound to be teething problems. It has generally been Double A rated banks that have thus far been able to benefit from the structure. Whether lesser-rated issuers will be able to do likewise remains uncertain. Their more modest requirements also do not necessarily lend themselves to an institutional market looking for large, liquid deals. While the retail sector can be looked at to pick up some of the slack for core Tier 1, name recognition is a key consideration, and smaller borrowers could find themselves with few options.
It looks certain that the euro true perpetual market will play a larger role in prospective issuers' deliberations in the future. As to whether this will be translated into actual supply is another question entirely.