Innovative UBS Tier 2 slumps

UBS last week priced the first European Tier 2 issue that allows for bondholders to be permanently written down to zero, but the deal’s performance and debate around its features showed there is still a long way to go before these structures are readily accepted.

Despite attracting US$5.5bn of demand from 370 accounts, the US$2bn 10-year non-call five low-trigger issue dropped by almost three points the day after pricing, though it recovered to a 99 cash price on Friday.

“This deal alters the landscape for what issuers will have to pay for new-style Basel III Tier 2 transactions,” said a senior DCM syndicate banker.

The issue was priced with a 7.25% coupon, the tight end of the 7.5%-area guidance.

Various bankers not involved in the deal had different ideas about where a Tier 2 issue with permanent write-downs and non-viability language should be priced. Many felt it should have needed no more than 50bp–100bp on top of existing UBS Tier 2 capital, but in the event the bond was priced 200bp behind, indicating that investors wanted to be paid a lot more for the risk of a permanent write-down.

Analysts at Barclays estimated the differential to be much wider – at 267bp – and compared the deal to the Rabobank Senior Contingent Notes, where they said the differential with Lower Tier 2 was in excess of 300bp.

Contingent, but not CoCo

UBS’s management has argued vehemently against CoCo notes, which potentially convert into equity, favouring instead write-off bonds.

Analysts estimate that the bank needs to issue as much as SFr23bn (US$25bn) of low-strike loss-absorbing capital to fulfil the low-trigger buffer, based on current Basel III risk-weighted assets, so the deal was a key test of investors’ appetite.

Under the terms of the issue, the bonds can be written down permanently if the bank’s common equity Tier 1 ratio falls below 5% or the bank is considered non-viable. The bonds have a one-time call after five years – if they are not called the coupon resets to five-year mid-swaps plus 606.1bp.

The turbulence surrounding Greece and the announcement from Moody’s that it might cut the ratings of 17 global and 114 European financial institutions – possibly including a three-notch downgrade for UBS itself – were blamed for the deal’s poor performance by those involved.

However, while observers agreed that these developments had not helped, the broad consensus of those away from the deal was that the issuer had taken too much in view of the relatively shallow demand for the product from institutions.

“I thought the transaction was too big,” said a senior syndicate banker. “They filled the private banks, which – added to the Moody’s news and general poor backdrop – meant that it struggled.”

Other bankers echoed this view, saying UBS should not have raised more than US$1.5bn.

“Private banks were the main buyers and there was not much institutional participation because many of them thought this should have priced 100bp wider,” said one.

Lead managers UBS (global co-ordinator), BNP Paribas, Commerzbank, Deutsche Bank and Societe Generale insisted that execution was not to blame.

“The performance on the deal is consistent with the performance of other Lower Tier 2 and contingent capital,” said one person involved.

“Indeed, this deal has performed better. The timing of the Moody’s news was unfortunate but one has to look beyond 12-hour windows for trading performance. And one can’t forget the market backdrop is still not stable.”

Lack of institutional demand

The key discussion point during marketing was how remote the trigger was. To breach a 5% common equity Tier 1, UBS would have to make a SFr22bn loss, people involved estimated.

Final distribution saw private banks buy in excess of 70% of the deal as many institutional investors stayed away. These statistics contrast sharply with last year’s Credit Suisse Tier 2 Buffer Capital Notes, which attracted more than US$22bn of demand.

A mere 34% of the Credit Suisse deal was sold to private banks, while institutional investors, which tend to favour a conversion into equity, took 48%.

“We would much prefer to see instruments that convert into equity given that it is not possible to forecast what the shape of the next crisis will be and what might cause a bank to hit a trigger,” said Satish Pulle, portfolio manager at European Credit Management.

“With something that converts, at least you get the opportunity of some upside rather than being stuck with an instrument that becomes effectively worthless.”

“A possible permanent write-down is not really a reason not to buy something. At the end of the day, most bonds, one way or another, can end up being written down in a distressed situation”

Credit Suisse was less reliant on Asia as well, selling 22% of the BCNs there versus close to 60% for UBS.

Permanent write-downs

Nonetheless, permanent write-downs are generally expected to become part of the next generation of bank capital instruments, one way or another.

“The market is going to have to become more comfortable with these structures,” said Andrew Fraser, investment director at Standard Life. “A possible permanent write-down is not really a reason not to buy something. At the end of the day, most bonds, one way or another, can end up being written down in a distressed situation.”

He argued, however, that this type of deal might prove available only to highly rated banks or those with access to private wealth networks.

The lead managers said it was essential to account for the Swiss regulatory requirements, which will require banks to have a minimum 10% common equity Tier 1 ratio by 2019.

“The transaction needs to be put in the Swiss context where banks are going in one direction capital-wise – and that’s up,” said Max Jacob, head of DCM bond solutions at Commerzbank.