Barclays Pays Wipeout Reward on Capital Securities: U.K. Credit

Barclays Plc paid yields almost four times those on its senior bonds to sell $1 billion of contingent capital notes, rewarding investors who can accept being wiped out in a crisis at the U.K.’s second-largest lender.

The 10-year bonds, which will be written down to zero if Barclays’s capital ratio drops below 7 percent of risk-weighted assets, priced yesterday to yield 7.75 percent, according to data compiled by Bloomberg. That compares with an average of about 2 percent for the lender’s notes included in Bank of America Merrill Lynch’s Euro Banking Index.

“Either you’ve done your credit work, see Barclays as a good bank, so you take the yield and say ‘Happy Days’,” said Bryn Jones, a London-based fund manager at Rathbone Brothers Plc, which manages the equivalent of $4.6 billion of fixed income. “Or maybe it’s like in the old cartoons when you see the characters with dollar signs in their eyes just as they race over the edge of a cliff.”

Barclays is bolstering reserves as it seeks to meet new Basel 3 regulations requiring banks to hold enough capital to survive financial turmoil without government bailouts. The London-based bank is taking advantage of demand for riskier assets as sovereign bond yields hold close to record lows.

Junk Debt

Benchmark 10-year U.K. government bonds yield 1.75 percent. Gilts returned 0.89 percent this year, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. German bunds gained 0.44 percent and Treasuries 0.13 percent.

Barclays offered on March 26 to buy back two issues of subordinated bonds due 2017 and 2020. The new contingent notes will “effectively replace” those securities, according to Simon Adamson, an analyst at CreditSights Inc. in London. The lender today reduced the cap on how much it will accept for the cash tender offer, to a maximum of $850 million from $1 billion.

The contingent capital notes are expected to be rated BBB-by Standard & Poor’s and Fitch Ratings, the lowest investment-grade rankings, Barclays told investors in a presentation on March 26. The bank paid more to sell the notes than investors demand to hold junk-rated debt, which yields an average of 5.58 percent in Europe and 6.41 percent in the U.S., according to Bank of America Merrill Lynch Indexes.

Investors in the contingent notes will take losses before shareholders or deeply subordinated Tier 1 bondholders.

“It’s a horrid structure,” said Robert Kendrick, a credit analyst at Legal & General Investment Management in London, which oversees about $585 billion. “You are explicitly subordinated to shareholders. That being the case, you should get paid more than Barclays’s cost of equity and I don’t think anyone believes that is 7 or 8 percent.”

Equity Capital

Barclays puts its cost of equity capital at about 11.5 percent, a figure that reflects the market consensus, according to Shailesh Raikundlia, an analyst at Espirito Santo Investment Bank in London.

Barclays is “profitable, strong and well-capitalized,” London-based spokesman John McGuinness said in an e-mailed statement.

Under new, stricter criteria on what counts as capital that regulators are introducing, Barclays will probably be obliged to hold loss-absorbing instruments, including common equity, equivalent to 9 percent of risk-weighted assets. The bank plans to hold a minimum ratio of 10.5 percent, according to the presentation made to investors.

Barclays first issued contingent capital notes in November, when it raised $3 billion in 10-year bonds priced to yield 604 basis points more than Treasuries. The deal, which ING Groep NV analyst Mark Harmer said attracted more than $17 billion in orders, now yields 600 basis points more than U.S. government debt, or 7.77 percent. The bond pays a coupon of 7.625 percent.

KBC Groep

KBC Groep NV, Belgium’s biggest bank and insurer by market value, issued $1 billion of contingent capital notes in January, paying a coupon of 8 percent.

Barclays can buy back its new securities after five years, which gives the bank the flexibility to replace them with more junior securities, according to Steve Hussey, a London-based analyst at AllianceBernstein Ltd., which manages $430 billion.

About $49 billion of contingent capital securities have been issued so far, data compiled by Bloomberg show, and Hussey estimates that as much as 300 billion euros ($385 billion) of the notes may be sold within the next five years.

The debt is comparable with low-rated corporate issues, he said. Company bonds ranked four to six levels below investment grade yield an average 7.10 percent, according to Bank of America’s Single-B Euro High Yield Index, compared with 7.75 percent for the Barclays deal.

“For the yield and returns you’re getting, these make sense for a high-yield mandate,” said Hussey. “People talk about the dangers of these being triggered but, aside from a catastrophic, one-time loss, regulators should have stepped in and forced the bank to act before you get anywhere near that.”