European banks indulged in an orgy of liability management exercises (LMEs) in the run-up to the 2011 year-end, with €46 billion-worth of bonds from 10 different transactions between mid-November and mid-December. The trigger for this spate of activity seems to have been a shift in regulatory sentiment after the latest European Banking Authority stress tests. "Activity may have been spurred on by the focus of the latest EBA stress tests on core tier 1 capital," says Vinod Vasan, head of European FIG DCM at Deutsche Bank. "In particular, some regulators have not required replacement capital, allowing for banks to manage for maximum core tier 1 in the short term."
This might result in a continuing run of deals in the first quarter of 2012 although the feeling in the market is that most of the big exercises have already been undertaken. With BNP Paribas and Société Générale both having come to the market, Crédit Agricole is a clear tip for issuance, as is RBS after recent Lloyds and Barclays trades.
Subordinated bank debt is under intense pressure, having been the worst performer in the credit markets in 2011 (see chart). Liability management exercises not only ease refinancing pressure and create core capital but also help manage down ineligible subordinated debt under Basle III. But this is a very different round of deals to those in 2009. "Deals such as the Lloyds lower tier 2 exercise were fair to investors but others have been painful to investors compared with 2009," said Christy Hajiloizou on the credit trading desk at RBS in a December conference call. "Issuers can take advantage of discounted cash prices and poor liquidity to back investors into a corner."
| Subordinated bank debt tanked last year |
| Total returns, normalized (Jan 2011 = 100) |
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| Source: RBS Credit Strategy, Bloomberg, iBoxx |
Investor backlash
Santander’s offer to swap €5.5 billion and £1.1 billion ($1.72 billion) tier 2 bonds at cash prices of between 87 and 99.5 into four-year senior unsecured notes triggered a furious backlash from investors in late November. While the deal was seen as aggressive the fact that the markets sold off after launch didn’t help – the seniors traded down while the lower tier 2 bonds didn’t move. "Santander may have redefined the market as they did the trade without a premium," says one banker. "If a premium had been there to cover the market move the reception might have been different but it was still a cuspy trade. Investors were holding a bond that was trading like it was not going to get called. They were offered a cash step-up and an improvement in seniority. This was not a bad concept – the problem with the trade was that it was a stingy trade."
Although other banks, notably BNP Paribas and SocGen, also launched junior debt exchanges, Santander’s offer drew particular ire. "The market views this trade as a one-off," said Sue Wallace, head of European financials credit trading at Citi, at a November conference. "People still believe that national champions are still prepared to call. It is a sign of strength."
Wallace cited the call of a Banca Intesa sterling deal as evidence that other banks from distressed sovereigns are still prepared to call deals. But the funding challenges that many banks face has made investors nervous. "The Intesa sterling tier 2 deal that was called on November 30 was trading the day before at 95," says Wallace. "People don’t believe the call notice until they see it."
With good reason, as the recent round of liability management trades has marked a fundamental change in issuers’ attitudes towards calling. "We are seeing deals include clauses only calling on an economic basis," explains RBS’s Hajiloizou. "This removes the reputational risk of not calling and subordinated bondholders are realizing that issuers will not just call for reputational reasons any more. This is a lot less clear cut than it used to be and the secondary markets are pricing this in."
Clarity of intent will be necessary if banks are going to be able to continue to launch liability management exercises. "Investors have already woken up to the fact that deals won’t be called," says one banker. "Even a year ago if you were sitting on a tier 2 instrument trading at 90 and you thought that you were going to get called you were kidding yourself."
ING announced a senior-subordinated exchange just before Christmas and the expectation is that several similar deals will be announced during the first quarter. "In 2012 the markets may bifurcate between those that are doing liability management trades because they want to generate core capital and those that are doing Basle III transformational trades," Andrew Burton, co-head of liability management for EMEA and Asia at Credit Suisse, tells Euromoney. "Because the debt capital markets are challenging, there has been more emphasis placed on the messages delivered through liability management offerings. This has been an educational process for some banks as four years ago banks generally didn’t do liability management exercises. Banks that are well capitalized may move early to do Basle III transition trades – essentially paying investors to transition into more risky new hybrid debt that provides regulatory capital into the future."
The right price
For those banks that need to raise capital, getting the pricing right will be crucial in light of the reception given to offerings that have been deemed too aggressive. Santander was recently identified by the European Banking Authority (EBA) as having a capital deficit of €15 billion and there was only 25% take-up of its debt exchange. In contrast, Lloyds’ recent lower tier 2 exchange, which was widely praised in the market as offering genuine new bonds and reasonable upside, attracted a 61% take-up. "If you are undertaking liability management to raise capital there will be some kind of inflexion point whereby if investors aren’t offered enough, the capital impact will be minimal as there won’t be sufficient take-up of the deal." says Vasan.
The capital shortfalls that the EBA stress tests revealed in early December together with continuing dysfunction in the senior FIG debt market will certainly act as a spur to issuance in 2012. "We expect to see liability management exercises for the next few months but in the longer term we need to see how the EBA stress tests play out," says Duane Hebert, head of liability management for EMEA and Asia at Deutsche Bank. "The issues in the funding market are feeding through to liability management in the form of exchanges rather than cash tenders." There will be some of the latter, however. For example, in December the UK’s Yorkshire Building Society announced its intention to buy back and cancel government-guaranteed debt.
Bankers generally believe that the lessons of the Santander trade have been taken on board and despite the questions that remain over callability new deals should be well received. "The Santander deal was the only significant transaction recently where investors lost money whether they exchanged or not. Others generally offered some value," says one. "There are a very limited number of issuers that would not think carefully about the ramifications for investors of aggressive liability management exercises. They don’t have room to be cavalier with the investors that are going to support their long-term financing plans."
