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Investing In Investment Grade Credit: New year’s resolution

There once was a time when European banks used an economic rationale to determine where in their capital structure they would raise finance. But since the financial crisis, the decision to use a particular form of paper is as much influenced by central bank policy and compliance with regulations as any pure business case.

Last year was no exception – policy initiatives and regulatory compliance helped to shape bank issuance. The ECB introduced Targeted Longer-Term Refinancing Operations (TLTRO). This initiative, replacing the previous round of LTRO, aimed to provide cheap financing to European banks as long as they can demonstrate they have lent to small and medium-sized enterprises.

“It was initially expected that TLTRO would effectively do away with senior debt issuance as banks would be able to access this much cheaper form of financing,” recalls Anne Velot, head of active euro credit at AXA Investment Managers.

However, take-up of this cheap financing has been lacklustre, mostly coming from peripheral euro-zone banks because others lacked the confidence that they could achieve the net-lending requirements the ECB imposed on the facility.

Contingent

But while TLTRO has had limited impact on bank issuance, other regulatory requirements have had a much bigger influence. Under Basel III, banks must maintain additional capital as a buffer against future losses, including a minimum of 1.5% additional tier-1 capital (AT1), as percentage of their risk-weighted assets. AT1 is the new version of hybrid tier-1 capital, which is the supplement of common equity tier-1 capital – by issuing AT1, banks can raise cheaper capital, often in the form of debt. 

The Basel III regulation, however, allows national regulators some flexibility over the precise nature of the type of instruments which would qualify as AT1, and each region has interpreted the legislation in its own way.

Mark Robinson, financial institution analyst at M&G Investments, says: “The EU decided that AT1 capital had to have a contingent convertible or a write-down feature included in the instrument.” This has resulted in the contingent convertible bond, or ‘CoCo’.

While senior debt issuance has outstripped subordinated debt issuance, the popularity of AT1 instruments has pushed net subordinated debt supply into positive territory, while net senior debt supply remains negative; about €250bn of senior bank debt was issued during 2014 but some €300bn was retired as banks de-leveraged their balance sheets, whereas the €100bn of subordinated issuance was met with only €50bn coming out of the market. 

The majority of the issuance, however, was AT1 debt – excluding AT1, only €10bn, net, of other forms of subordinated debt was issued. That has made AT1 a very fast growing asset class. 

“That’s related to the Basel III regulatory requirements – banks need to fill their capital requirements and manage their leverage ratios,” explains Andreas Doerrenhaus, portfolio manager for BlackRock’s global unconstrained fixed-income strategies.

So far, it has been the higher-quality European banks issuing this type of debt this year. In 2015, however, the supply of AT1 debt could become more diversified. 

“It will be interesting to see how the market would react to more AT1 issuance from banks with weaker fundamentals – they might demand a higher risk premium,” says Doerrenhaus. 

Even if these banks have to pay higher spreads to investors than their fundamentally sound competitors, AT1 issuance will be more cost-effective than equity to meet their regulatory requirements, he adds.

There is also hope that banks may be coming to the end of their current deleveraging cycle, leading to positive net supply of senior debt through 2015. 

Total loss-absorbing capacity

While more banks are likely to continue to issue AT1 and there are hopes that senior debt issuance will recover, behind all of this a new reg-ulatory regime that requires banks to have a certain level of ‘total loss-absorbing capacity’ (TLAC) is likely to have a longer-term impact on bank issuance.

Ed Felstead, financial institution analyst at M&G Investments says: “The Financial Stability Board has made a proposal to harmonise requirements, such as Europe’s Minimum Requirement for Own Funds and Eligible Liabilities in Europe, and Primary Loss Absorbing Capital in the UK.”

TLAC goes some way to quantifying the amount of a bank’s liabilities that can be counted as loss-absorbing – the assets that would be used to achieve a resolution in the event of the bank’s business failing. In theory, such a resolution would enable important systemic functions such as payment systems to continue in a way that a disruptive bankruptcy procedure would not. It has been acknowledged for some time that even senior bank debt is not safe from being ‘bailed-in’, or used as loss-absorbing capacity, in such a resolution. 

“The authorities want the banks to have a huge amount of debt which can be bailed in before they have to turn to the government for support,” explains Robinson.

While the FSB paper is still a proposal, there are some indications about which type of instruments will be counted as loss-absorbing. Beate Muenstermann, managing director at JP Morgan Asset Management, says: “The draft document has suggested that senior holding company debt – tier-1 or tier-2 instruments – will be counted.”

Complicating the TLAC discussion is a choice between single and multiple-point-of-entry resolution plans – that is, whether loss-absorbing debt should be held by holding companies or operating companies. 

It would be simpler for TLAC to be held by holding companies rather than operating companies as this gives a resolution a single point of entry – the funds can then be utilised to recapitalise entities anywhere in the group. But there are a couple of problems with this. Most importantly, European banks outside of the UK and Switzerland do not tend to have holding-company structures. 

“Given the cross-border nature of large banking groups and the competing requirements of national regulators, some banks have chosen a multiple-point-of-entry approach, and will have to ensure there is TLAC at each location,” adds Felstead.

There is some indication that 2.5% of the TLAC buffer could be operating-company debt – which would make sense, as this is where most common senior debt is issued by Europe’s banks, but presents its own stumbling block. 

“There is some doubt whether this senior operating-company debt can count as it is pari passu with large depositors,” Muenstermann observes. “In order for it to be included [as TLAC], European insolvency laws would have to be changed.”

Clearly there are still many uncertainties to be ironed out – which forms of debt will be considered loss-absorbing, and the extent to which holding or operating-company debt is preferable or eligible. And even when the finalised report is published, it will be only a set of guidelines and national regulators will decide how closely to follow them – some may allow senior debt to be considered and some may not. 

Whatever the outcome, most agree that TLAC will have a major influence on the European bank-debt market – and indeed some banks are already taking steps. Felstead notes that even non-EU Swiss banks are planning to issue debt that would be contractually loss-absorbing from the top of their group structures, their holding companies. US and UK banks have been doing the same for some time, he adds.

“The introduction of a total-loss-absorbing capital requirement has the power to dramatically shape the supply dynamics of the European bank issuance market,” says Doerrenhaus. “If regulators want banks to issue more senior debt which can be bailed-in, that is what will happen.”

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