Bond investors attack design of new Tier I capital
Bond investors have attacked the template laid out for new regulatory capital instruments in Europe’s version of Basel III, arguing potential purchasers will shun so-called additional Tier I (AT1) products when they realise how risky they are.
So far, the market has seen only one issuance since the criteria were laid out in the fourth Capital Requirements Directive (CRD IV) – from BBVA in April – but it was heavily oversubscribed, and analysts expect up to €200 billion of this new debt to be sold as banks adjust to the capital regime.
The rules set a conversion trigger of 5.125%, at which bonds will either be converted into equity or written down. They also require the instruments to have a perpetual maturity – with early redemption only possible after five years, subject to strict constraints – and banks must be able to suspend coupon payments at any time. Those equity-like features give regulators comfort that the capital will be genuinely loss-absorbing, but they alarm some traditional bond buyers.
“From a bondholder’s perspective, it is a disastrous instrument. Mainstream fixed-income investors should have nothing to do with this type of issuance,” says Roger Doig, a credit analyst at Schroder Investment Management.
Those criticisms are echoed by a London-based bond fund manager: “Contingent capital started off as fairly similar to existing debt instruments – the structures were fairly benign and the triggers pretty remote. We’ve gradually seen them get more and more aggressive, and less and less investor-friendly. We’re now at a point where banks might be able to decide at any point to just not pay you anything, which is unacceptable.”
The biggest concern for these critics is the discretionary coupon. “A fully discretionary zero coupon is a non-starter. You can’t really describe it as fixed income any more,” says Schroder’s Doig. “That, combined with the perpetual lifespan of the bond, is a really horrible feature. One day, people who own this stuff will recognise that while it may get valued as an instrument with an attractive coupon when times are good, the value floor for the instrument when the bank hits a period of stress and decides to cancel the coupon, is very, very low. There’s no incentive for the bank to ever reinstall the coupon payments. In that situation, the bank lives on but the investor is left with nothing.”
BBVA has been the source of the first – and so far only – issuance of compliant Tier I capital since CRD IV was finalised. The Spanish bank was looking to sell $1.5 billion worth of an equity-conversion bond with a 9% coupon. Buyers flocked to the product, generating an order book of $9 billion. Other banks to have issued contingent debt in recent years include Credit Suisse, which sought to ensure its 2011 Buffer Capital Notes would meet then-evolving international standards.
“Opportunities for high-yield investment are limited right now. Where else are you going to get a return of 5-9% from a high-quality name?” asks one fixed-income expert at a large European bank. “I’d expect to see some of the major European banks start to engage in Tier 1 debt issuance in the third and fourth quarters of this year, in advance of the adoption of CRD IV in January 2014.” Analysts estimate that total AT1 issuance from EU banks may reach €200 billion.
If demand continues to be strong, there may be calls for the instruments to be included in high-yield or investment-grade bond indexes, which would ensure added support for the market from benchmarked funds, warns Tamara Burnell, head of financial institutions at M&G Investments in London.
“There is always a danger that if one of these instruments does get included in the investment-grade indexes, then index-benchmarked funds are going to find it difficult to avoid the asset altogether. It’s hard to see how this stuff could find its way into investment-grade indexes, but the pressure from the banks to get it in will be intense,” she says.
Burnell isn’t confident of investors’ ability to withstand this squeeze. “It will definitely be a big challenge. The buy side has been poor in dealing with these sorts of threats in the past. It’s all down to the index providers, and most of them are investment banks. I’d like to think regulators are looking into the financial stability ramifications of index providers effectively creating a book for their own debt, but maybe that’s a little too optimistic,” she says.
This article was first published on Risk