On December 17 2008 Deutsche Bank signalled it would not be exercising the call option on its €1bn 3.875% January 2014 Lower Tier 2 issue the following month. The news caused a collective intake of breath from market participants on all sides of the business.
With the extension risk genie well and truly out of the bottle, issuers had some tough decisions to make, weighing up economic versus reputational risk. Investors had to reassess perceived redemption certainties, while intermediaries were left wondering what advice to offer buy-side and sell-side clients, and whether there would be any common ground for the foreseeable future.
Fast forward half a year, and it was again Deutsche at the forefront of events, this time offering evidence as to how much the landscape had changed. It sold a €1bn seven-year Pfandbrief – its debut in the asset class – on the same day it announced it would not call a US$650m Tier 1 issue.
That might have caused some reticence among investors about participating in any Deutsche deals. But it didn’t: the €5.5bn book was the largest seen for a covered bond all year, a far cry from December when the level of opprobrium heaped on the bank was remarkable. Not only did any threatened buyers strike fail to materialise, but the latest extension event barely prompted a mention.
At the time Deutsche’s said the LT2 that “replacement costs would be more expensive than the existing…coupon”. Market participants retorted that this would be more than outweighed by the reputational damage it would endure as a result. Yet since then the market has changed fundamentally. The cost of capital now plays a far greater role.
Towards the end of August, Deutsche launched a €1.25bn Tier 1 deal, unthinkable just a few months previously. Admittedly, its perpetual non-call 5.5-year non-step was targeted at the retail sector, and therefore largely sidestepped the institutions that had been the most vocal in their criticisms (a 9.5% coupon did no harm, either). Nonetheless, it underlined just how far things had come: the year has not been all about Deutsche Bank, but its experiences have been a microcosm illustrating the changing landscape.
Spreads on hybrid securities have been on a tightening bias all year, with cash-rich investors displaying a willingness to participate in a higher-yielding asset class. This is despite events unfolding that would have been virtually unthinkable before the crisis, from non-calls, through coupon deferrals on LT2s to regulatory restrictions on coupon payments from banks.
For issuers this has been an unexpected bonus. A sector where bondholders cannot be sure of being paid coupons, or, in some cases, principal, does not seem an obvious investment opportunity. The levels at which the myriad tenders and exchanges that have taken place over the course of the year – now well in excess of €100bn-equivalent – offer an indication of how many of the outstanding issues have performed since launch.
Ultimately, buyers – often of the retail persuasion – now believe they are being adequately rewarded for the risks they are taking on. The market is therefore open, and issuers in Tier 1 and Tier 2 are taking advantage of the capital options available at the moment.
While we are still far removed from the depths of returns seen pre-crisis (levels that even at the time seemed crazy and unsustainable), issuers are increasingly able to negotiate less onerous terms, as demonstrated by the progression of coupons in the bank Tier 1 market.
February saw Mizuho print with a 14.95% coupon on an US$850m perpetual non-call five. Rabobank offered 11% its May non-call 10 transaction that included new and exchanged securities (followed up by a SFr550m 6.875% non-step in July, the lowest coupon achieved in the year to date).
Standard Chartered paid 9.5% in mid-June for a US$1.5bn 5.5-year non callable that steps up after 10.5 years. The same week saw Credit Agricole come at 9.75% with an US$850m non-call 5.5 non-step.
In the euro sector, the aforementioned Deutsche deal at 9.5% and SG (€1bn perpetual non-call 10) at 9.375% late on in August saw the market largely treading water. The pace really picked up in September, certainly in dollars, exemplified by Nordea’s US$1bn issue in the same structure as Standard Chartered at 8.75%. NAB, which managed a flat 8% coupon on its US$600m non-call seven with a 14-year step.
“The re-emergence of a sub-debt market has been for many in the market the first real green shoots,” said Andy Sweeney, vice president, debt syndicate at RBC CM.
And all the while, uncertainty surrounding the future regulatory landscape continues - something that makes investors’ willingness to participate all the more noteworthy.
The Group of Central Bank Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, met on September 6, with the aim of strengthening the regulation of the banking sector.
With regards to Tier 1 capital, it said that banks should “raise the quality, consistency and transparency of the Tier 1 capital base. The predominant form of Tier 1 capital must be common shares and retained earnings”.
While it therefore appears that core Tier 1 will play a greater role in the capital structure, the use of the word “predominant” is intriguing: it keeps the door open for hybrid securities, even if the amount and nature remains uncertain.
“Society needs an efficient banking system, so banks need to have an efficient capital structure and hybrids are intended to create efficiency through a lower cost of capital,” said Steve Sahara, global head of DCM solutions at Calyon. “Efficiency created by hybrid capital securities allows for more, and a faster generation of, retained earnings – the best form of capital. It also supports counter-cyclical capital provisioning: hybrid costs are fixed so in boom times even more core capital can be built up in reserves.”
While governments have the right to a voice in any regulatory discussion, excessive new capital requirements are a “chastity belt approach to risk management”, he said. It does not address the real problem: excessive risk-taking.
“If new capital security requirements result in securities that are not attractive to investors there may be reduced market access for second and third-tier banks that often provide a key role in local economies,” he added.
The BIS intends to produce concrete proposals by the end of this year and will carry out an impact assessment at the beginning of 2010, with implementation earmarked for the end of next year.
Ratings by a thousand cuts
The rating agencies provide another layer of uncertainty as they adapt their approaches to better reflect the new world order. This is particularly pertinent when it comes to banks that have availed themselves of state aid and which might therefore come under regulatory/political pressure when issues of call options or coupon deferrals arise.
Moody’s is looking at removing systemic support from its hybrid ratings and introducing wider notching differentials between different subordinated asset classes, leading to more issue-specific prices. Fitch is similarly looking at how state aid might impact hybrids and is likewise increasing notching. S&P will widen the notching on LT2s in jurisdictions where there is the possibility of a coupon deferral that does not trigger a default.
Although greater notching – especially if it results in a multiple downgrade – could cause difficulties to some investors, with new ratings no longer fitting their investment criteria, the market has proved remarkably resilient. Most of the initiatives were instigated during the summer months, during which time hybrids enjoyed the most aggressive tightening of their now lengthy bull run. Borrowers showed a remarkable willingness to embrace whatever terms were required for them to sell their paper, although arguably they had little choice. This laudable pragmatism served to re-engage investors to a sufficient extent give the market the jolt it needed.