European banks seeking to meet capital targets by selling contingent convertible bonds may struggle to attract investors after regulators imposed limits on the form the instruments must take.
The European Banking Authority said last week lenders could use the securities, bonds that convert into equity or are written down if a bank’s capital drops below a set level, to help plug a 115 billion-euro ($153 billion) capital shortfall. It published a standard set of terms for the securities, which investors said were unlikely to be attractive to buyers because the risk of triggering a conversion is too high and issuers will have too much control over interest payments.
“The majority of institutions that actually need capital to reach the EBA target will not be able to attract private investors for these instruments,” said Satish Pulle, a portfolio manager at London-based European Credit Management Ltd., which oversees a fund that invests in CoCos and bank debt.
European regulators are trying to force lenders to boost their ratio of core Tier 1 capital to 9 percent of risk-weighted assets to reassure investors they can withstand the sovereign debt crisis. CoCos allow banks to raise capital without diluting existing shareholders, something that’s become more attractive after European bank stocks plunged 34 percent this year.
For CoCos to be counted toward the EBA’s target, the regulator said they should convert into equity when a lender’s core Tier 1 capital ratio falls below 7 percent of risk-weighted assets, a level some investors say is too close to today’s capital levels.
Lloyds Banking Group (LLOY) Plc, the U.K.’s largest mortgage provider, sold 8.5 billion pounds of CoCos in November 2009 that convert to equity if core capital drops below 5 percent. The ratio was at 10.3 percent at the end of September.
Rabobank Nederland, Europe’s biggest agricultural lender, issued $2 billion of the securities in January with an 8 percent trigger. It has a core Tier 1 capital ratio of 12.7 percent today. Credit Suisse Group AG (CSGN), Switzerland’s second biggest bank, sold $2 billion of Tier 2 CoCos with a 7 percent trigger in February and announced plans to issue a further $6.2 billion of Tier 1 securities in October 2013 at the earliest. The Zurich-based bank has a Core Tier 1 capital ratio of 12.6 percent.
Credit Suisse offered investors a 7.875 percent coupon on its Tier 2 securities and plans to offer 9 percent and 9.5 percent coupons on its Tier 1 CoCos. Rabobank paid an 8.375 percent coupon. Struggling banks may need to offer as much as 14 percent to attract investors, according to David Serra, managing partner at Algebris Investments.
“Strong banks will find it easier to find buyers but they may decide it is an expensive way to raise capital,” said James Friedman, a partner at the London-based hedge fund, which invests in CoCos and other bank securities. “For stressed banks it will be difficult.” Lenders would prefer to reach the target by reducing assets and retaining earnings rather than selling CoCos that carry a high interest rate, he said.
Under the EBA plan, banks also have the option of stopping interest payments and can repay investors at face value after five years, potentially depriving buyers of any gains.
“Banks have complete discretion to stop paying the coupon, which may put some people off,” said Mike Harrison, a bank analyst at Barclays Capital in London. “They are much closer to equity than fixed income.”
Romain Sadet, a spokesman for the EBA in London, said investors were consulted in the process of drafting the term sheet. The guidelines needed to be “sufficiently strong” for the securities to comply with the Basel Committee on Banking Supervision’s rules that come into force in 2013, he said.
One possible draw for investors is the inclusion of a clause allowing banks to offer holders the right to convert their CoCos into shares in the future. “The fact there may be an option for equity upside is an interesting twist,” said Algebra’s Friedman.
When Credit Suisse sold its CoCos, Standard & Poor’s said the market for the securities could eventually surpass $1 trillion -- three times the value of all high-yield bond offerings last year. CoCo sales have so far failed to live up to that estimate after the sovereign debt crisis roiled credit markets, and the Basel Committee said in July the instruments couldn’t be used in the additional capital buffer it will require the world’s biggest financial institutions to maintain.
The standardized set of terms will make it easier for governments to inject capital directly into struggling banks without buying equity, investors said. Governments in Southern Europe may be forced to provide capital to their lenders if they are unable to raise capital from investors by the end of June. Governments may prefer to buy CoCos because they will receive interest payments and won’t dilute shareholders, investors said.
“These instruments look suitable for sovereign investors, which would be a welcome development,” said Pulle at European Credit Management. “We hope this will be a step towards Europe investing in its own banks.”
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