Sweet spot

IFR Top 250 2014
11 min read

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Politicians and regulators have been at pains to insist that the relationship between sovereigns and banks has changed. Governments have made it clear they will not be stepping in to rescue banks in the future. Their words have been backed up by a host of regulations – such as bail-in and the massively increased demands for capital buffers – designed to ensure they don’t have to. Such has been the frequency and apparent sincerity of their words, investors cannot help but have taken these sentiments on board.

“Everyone understands there will be no further government assistance for banks and investors analyse each deal on its own merits with that in mind,” said Andre Muschallik, head of FIG at Deutsche Bank.

“Investors will look at the borrower, at its capital structure, at its liquidity and its solvency. They are mindful of the jurisdiction too, but that is certainly less of a concern to them than it was two years ago.”

Yet it remains unclear to what extent investors are analysing credits on their individual merits. Financial institutions are enjoying conditions that are as attractive as at any time since the crisis, almost regardless of their circumstances.

“Investors have not priced in the risk of bail-in yet,” said Sebastien Domanico, global head of FIG at SG. “The difference between banks with a significant capital buffer and those without is not showing up in the price.”

Academic bail-in

“Bail-in is a little bit academic at this point,” said Edward Stevenson, head of FIG DCM at BNP Paribas. “Banks have such high capital ratios now that the quantum of losses required for losses at the senior level is very high. The risk associated with senior debt is therefore very limited.”

The positive mood is a global phenomenon, though Europe has been the most active region for FIG issuance, be that in covered bonds, senior unsecured or perpetuals. A few local issues have held back deals in some countries – questions concerning tax treatment in the Netherlands or rules concerning the workings of loss absorption in Spain – but these have not been issues undermining market sentiment, said Domanico.

Things have come a long way since the days in the aftermath of 2008 when covered bonds, along with the LTRO, were the only funding options available to many banks – and even then at a premium. Covered bond spreads have now tightened beyond pre-crisis levels to the point that there is little room for further tightening.

Despite these appealing spreads, many are opting to pay a little extra in the senior unsecured market, although from a funding perspective, covered bonds have proved themselves reliable in times of crisis, meaning banks trust they will be available as a last resort.

“The question is not about funding, it is about capital,” said Armin Peter, head of European debt syndicate at UBS. As subordinated debt, senior paper provides more capital protection on the balance sheet. Although market conditions are currently benign and there is little pressure on banks to build up further capital buffers, there is an appreciation that an external event could change things very quickly. Ukraine exemplifies how quickly geopolitical events can unravel.

“The issue with covered bonds is the encumbrance,” said Marcus Schulte, head of financial institutions DCM in EMEA at Credit Suisse. “It weakens the balance sheet so some issuers have been more hesitant to rely on this route, namely in times of more moderate funding advantages versus senior unsecured funding.”

“Issuers are sensitive around the use of collateral because of encumbrance,” agreed Peter. “And some simply don’t have the collateral available to do a covered bond, even if they want to, because they have used it all for previous transactions or as repo with the ECB.”

This has ensured that supply is tight, leading to a year of net redemptions, in turn ensuring demand – especially among banks themselves. Covered bonds’ eligibility for the liquidity coverage ratio and the net stable funding ratio has ensured that banks have been among their most enthusiastic investors.

Superior senior

Yet for investors looking for better returns, the spreads on senior unsecured paper have proved more appealing. Spreads on senior FIG paper have come in to their tightest levels since 2009 but remain on average wider than investment-grade corporates.

Investors evidently still see plenty of upside. Considerable time and energy has been spent reducing balance sheets, leaving profitability up and risk down. Banks are more selective about the investments they make, said Muschallik, particularly when it comes to sovereign credit.

Some banks are also declining the opportunity to buy back debt, to maintain generous capital buffers.

“In many cases it doesn’t make sense to buy old securities back if they are not Basel III-compliant because they give additional protection,” said Domanico. “In most instances, keeping those old securities out there in the market offers cheap protection, especially as some issues can keep some regulatory value.”

This is not a hard and fast rule. Lloyds bought back debt because it was paying so much on its CoCos. However, in most instances keeping old securities in the market offers cheap protection.

Rarity value

With smaller balance sheets has come reduced issuance in recent years, giving FIG supply a relative rarity value that has guaranteed demand. Deals are enjoying high quality books, with significant participation from real-money accounts. But some have questioned whether the relative valuations of bank debt are sustainable.

“The senior debt differential to covered and Lower Tier 2 will come under greater scrutiny,” said Sandeep Agarwal, head of DCM in EMEA at Credit Suisse.

“There is an argument that in a bail-in world a 25bp–40bp senior-to-covered differential is too tight, if the senior-to-LT2 differential is on average around 100bp,” though naturally “the absolute and relative level of spreads will of course move on technical and individual fundamental considerations”.

Some investor opportunism is therefore to be expected as they pick up yield where they find it.

“High-yield corporate and emerging market debt remains in demand but the subordinated debt and CoCos of high quality banks, some believe, provide good yield enhancement opportunities too,” said Mark Geller, head of European financial institutions syndicate at Barclays.

Even sub-investment grade issuers have enjoyed access, with the likes of Bank of Ireland and Banco Espirito Santo and even the National Bank of Greece getting deals away. This is in part due to improving market conditions, bringing with them a sense that these troubled banks are on the mend. Investors seem to view the base-case as being that national champions won’t get into trouble.

“In countries like Ireland, Greece, Portugal and Spain some banks have rehabilitated themselves very quickly,” said Chris Tuffey, head of debt syndicate in EMEA at Credit Suisse. “If you want to participate in the periphery revival story, then investing in bank debt or equity is a strong option.”

“Some investors have been buying peripheral paper for the euro convergence trade,” said Stevenson. “There is a feeling that these cheaper issuers will converge with core names in coming months.”

But it is also a result of QE-charged liquidity. “Investors have more liquidity than investment options,” said Muschallik. “If they are going to diversify they can’t afford to ignore the sub-investment-grade banks. It is partly a matter of choice but partly also a matter of necessity.”

“Technicals are too strong relative to fundamentals,” said Domanico. “This is not just a FIG issue, you see it in the sovereign and corporate markets as well. Eventually, the music will stop but there is no sign yet of when that might be.”

In the meantime, banks have also been preparing for the Asset Quality Review, aware of the need to ensure balance sheets are in order. This is not expected to have a big direct impact on FIG issuance, with any additional capital raising likely to be through equity or Tier 1 debt.

What impact the AQR does have is likely to be felt early. “Banks will adjust their capital structures pre-emptively rather than waiting until after the stress tests, and that is already starting to happen,” said Muschallik. Deutsche Bank has already announced a capital raising, though it insists this is unrelated to the stress test.

Other banks have also been busy raising debt. FIG issuance was up 20%–30% year on year in the first quarter, despite no growth in the economy to justify that additional capital requirement. However, this front-loading could mean supply tapers off later in the year. With demand already outstripping supply in the first half of the year, this could push spreads even tighter.

However, the mood among banks ahead of the AQR is relatively sanguine. “Most banks feel it isn’t really relevant to them,” said Stevenson. “There is a confidence that most will pass the test and although there are sure to be some that don’t, there have been hints that there will be no formal pass or fail announcements, and any bank that needs to raise additional capital will be instructed to do so.”

For any banks that do have concerns about the AQR, macroeconomic conditions are fortuitous. With the market receptive to yieldy, subordinated products, it looks like a good entry point for any bank needing capital. It could be the perfect opportunity to sell debt for stress test purposes without it being interpreted as an admission of weakness.

Banks understand that current market conditions cannot last forever, although a cooling off of the market in mid-May was seen as a pause for profit-taking, rather than a change of sentiment.

“Nobody knows how far QE is going to take us but the expectation is it will continue for some time yet,” said Peter. “At the moment, there is a view that no bad news is good news; people will look for the higher coupon because it’s all about the carry. It’s hard to trade against central banks and politicians.”

Cash indices of capital (Tier 1 & Tier 2) and funding (senior & covered)