Thursday, 19 July 2018

Guaranteed addiction

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The provision of state guarantees for debt obligations issued by financial institutions has been an important step in addressing bank instability and restoring market confidence in the wake of the global financial crisis. But aside the political cost of assuming such high levels of debt, governments must find a way of disengaging with the market so that banks can go back to functioning without their support. Hardeep Dhillon reports.

Most governments have permitted domestic banks to issue guaranteed debt from October 2008 until December 31 2009. A handful of countries are offering a sunset period, often between September 2010 and June 2012. The guarantee is granted to bonds issued by eligible banks, except in France and Austria, where a central agency structure is employed. In France, the state guarantee is granted to notes issued by Société de Financement de l'Economie Française, a newly created special purpose vehicle for refinancing French institutions (see profile on page 45).

Many schemes limit the maximum maturity for guaranteed obligations to between three and five years, and eligibility to newly issued senior debt – though Denmark and Ireland guarantee existing issues. Austria, Germany and Ireland include lower tier II obligations. Austria, Ireland, Sweden and Finland also offer a guarantee for covered bonds.

The guarantee schemes have been crucial in facilitating access to funding and strengthening the stability of financial markets by re-establishing market liquidity. “Guarantees have been one of the many instruments that have helped bring back confidence to the system and have reduced the perceived risk of a total financial meltdown,” said Willem Sels, head of credit strategy at Dresdner Kleinwort.

“In the eye of the storm post-Lehman, no one was prepared to fund financial institutions and the schemes have been extremely valuable and imperative for banks to obtain liquidity,” added one head of fixed income research at a brokerage.

The fee structure for state guarantees across Europe generally follows the recommendations on government guarantees on bank debt given by the European Central Bank on October 20 2008. Fees are usually based on the individual institution’s risk profile – either the median five-year credit default swap spread, credit rating or by individual determination. The US imposes a flat rate charge, regardless of risk, of 50bps-100bps, depending on maturity.

Fees for accessing the guarantee scheme can be expensive. The average cost for a European bank to issue a two or three-year government guaranteed bond could rise to about 150bp, said Franz Rudolf, head of financials credit research at UniCredit Markets & Investment Banking. SFEF bonds are on average 15bp-20bp tighter than comparable European GGBs, and are proving structurally attractive for investors.

“The SFEF model is a welcome approach for investors as they only need to familiarise themselves with a single issuance programme once, in contrast to other jurisdictions like Spain where there is one programme in place for each savings bank,” said Leef Dierks, fixed-income strategist at Barclays Capital.

Signs of a reversal

Global GGB supply had risen to over US$460bn by the end of May, with roughly US$370bn issued in 2009 alone. However, the pace of monthly GGB supply declined during the second quarter.

May’s issuance of US$45.9bn in GGBs was the lowest on record, down from a peak of US$144bn in March and US$70.6bn in April, according to Thomson Reuters data. This trend is being offset by an increase in supply of unguaranteed senior financial bonds, global issuance of which rose to US$49.9bn in May. This was the highest figure since August 2008, up from US$33.5bn in April, according to Thomson Reuters.

Combined with central banks pumping liquidity into financial institutions, the guarantees have successful relieved banks of their liquidity constraints. “The market is now at a stage where banks are starting to feel less reliant on government guarantees and are increasingly able to fund themselves independently,” said Grant Lewis, head of fixed-income research at Daiwa Securities SMBC.

The better-capitalised banks will want to differentiate themselves from weaker firms, and issuing non-guaranteed bonds is a sign of relative strength, said the fixed income head broker. “Banks could have a competitive advantage if they can demonstrate to the market they are strong enough to issue without a guarantee. The ultimate aim is to wean banks off government guarantees to completely restore confidence in the system,” he added.

Many US banks have raised non-guaranteed debt in an attempt to repay taxpayer money allocated by the US$700bn Troubled Asset Relief Program. Key conditions for repaying TARP funds include selling non-government-guaranteed debt and raising common equity.

JP Morgan, American Express, Bank of New York Mellon, BB&T Corp, Capital One Financial, Morgan Stanley, State Street Citigroup, US Bancorp, Goldman Sachs and Northern Trust have all expressed their intentions to pay back TARP money.

Across the pond

A similar picture is emerging in Europe. A sharp increase in the supply of unguaranteed senior euro-denominated bank bonds has been evident in the second quarter. Issuance has risen from €6.2bn (US$8.66bn) in March to €15.5bn in April and €23.6bn in May. Guaranteed supply accounted for €19.8bn in March, €19.9bn in April and €26.7bn in May, according to Société Générale Corporate & Investment Banking.

The absence of major shocks in the financial sector, strong bank earnings and rising equity markets have restored confidence and risk appetite, enabling more banks to issue non-guaranteed paper. “We’re seeing an increase in non-guaranteed issuance as sentiment towards the banking sector improves and banks become more willing to issue senior debt free of the shackles that come with a guarantee,” said Suki Mann, head of credit strategy at SG CIB. “Spreads/cost of issuance is still high but signs of a return to normality are welcome.”

According to Claudia Vortmuller, financials analyst at Commerzbank, the stronger banking names intend to avoid issuing more state guaranteed bank debt, and will instead look to place senior debt whenever a window opens up. They will also avoid calling subordinated securities. “The market for senior bank debt has re-opened. The same holds even for subordinated securities, although only very selectively,” she said.

It is a mixed picture for outstanding subordinated securities, said Vortmuller. Some banks intend to call issues at the first call date. Others, like Deutsche Bank, have a strict cost approach and have refrained from calling the subordinated securities due to the higher refinancing costs.

The majority of GGB transactions have been printed at the three-year maturity. This will result in a massive redemption hump of roughly €250bn in 2012, estimated Barclays Capital’s Dierks. Banks are now looking to extend their funding profiles by securing alternative sources of longer term funding, even if at a slightly higher price, he added.

“As market sentiment improves, we should see a renaissance in senior debt and covered bonds, which will both become relatively more attractive than the issuance of GGBs,” he said. “Despite the foundation of a new asset class and its intense market growth, the boom phase in the GGB market is already nearing its end.”

The ECB’s €60bn covered bond purchase programme, announced on May 7, has shifted the emphasis of state aid away from the GGB market and triggered a revival of the European covered bond market. Only eight jumbo transactions were issued between January and the end of April, compared to 13 in the three weeks after the ECB announcement.

Most of the active issuers of euro-denominated GGBs are also covered bond issuers. The re-opening of the primary market will therefore allow banks to issue at more attractive levels. “Depending on jurisdiction or name, spread levels on covered bonds are between 50bp and 120bp for longer maturities and this is considerably cheaper than using the GGB model,” said Rudolf.

An investor can achieve a spread of 20bp-40bp on a GGB, versus 50bp-120bp on a covered bond and 200bp-220bp for a senior unsecured bond of the same issuer. “An investor is able to trade the risk and spread performance and essentially choose the level of pickup he wants from different financial debt issued by the same bank, for instance, a Commerzbank senior or a Eurohypo covered bond,” he added.

Issuing covered bonds will be an important alternative or new funding instruments for banks, agreed Vortmuller. “Deutsche Bank has already done so with the setting up of its Pfandbrief programme and achieved a significant funding advantage.”

In general, the weaker banking names will continue to depend on state aid and issue guaranteed bank bonds. But negative surprises are still possible. “It is currently difficult to assess the degree of further value adjustments in the banks’ portfolios,” said Vortmuller. “Negative impacts on spreads are possible. In addition, the banks’ independent funding options could be drastically reduced again in a more pessimistic scenario.”

“Risk appetite remains fragile and many investors’ reluctance to upgrade their allocation to subordinated financials debt from their current underweight illustrates that very significant concerns remain with regard to capitalisation and potential bank failure,” added DK’s Sels.

Strong trading gains made by banks in the first quarter could easily prove to be a one-off occurrence. Some are predicting bank performance will be lacklustre again this year. It is possible that some banks will not be able to use the unguaranteed route and the market will be quite name selective. The so-called ‘national champions’ will be best placed,” said Matthew Maxwell, a financials analyst at SG CIB.

Though in decline, the GGB market will still have an important role for some firms through the course of the year, added UniCredit’s Rudolf. “Some issuers that do not have covered bond programmes in place or are too small to issue or encounter negative news flow, will still have to rely on the GGB programme.”

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