CoCo Market Seen Swelling to $80 Billion on Banks’ Review

The market for the riskiest bank debt will probably swell by more than 50 percent to $80 billion in Europe by year-end as lenders bolster capital ratios.

Faced with stress tests and an asset quality review in coming weeks, European banks will issue about 20 billion euros ($26 billion) more additional Tier 1 notes this year, according to Barry Donlon, head of capital solutions for Europe, the Middle East and Africa at UBS AG in London. There are about $52 billion of the securities currently outstanding.

Banco Santander SA issued 1.5 billion euros of the contingent capital, or CoCo, securities yesterday, reopening the market after an almost three-month hiatus that accompanied the collapse of Portugal’s Banco Espirito Santo SA in July. Italy’s UniCredit SpA priced a deal today and HSBC Holdings Plc, the biggest European lender, is planning a transaction before regulators publish their assessments of lenders prior to the European Central Bank taking over as supervisor in November.

“What you’re seeing now are the country champions where investors see the likelihood of a surprise in the review as very low,” said Donlon, who worked on the Santander deal. “They can issue opportunistically to take advantage of demand. For the others, there’s going to be a rush in November after the asset quality review.”

Santander originally said it may issue as much as 2.5 billion euros of additional Tier 1 securities, which would have left it with almost $7 billion of the debt outstanding. The new bonds, which were priced at par to yield 6.25 percent, were quoted at 98.8 cents on the euro at 4:55 p.m. in London, according to prices compiled by Bloomberg.

Policing Burden

Regulators created contingent capital bonds to push the burden of policing the banks on to investors by forcing bondholders to pay for collapses. They include additional Tier 1 securities, which are undated and have optional interest payments, so that in a crisis lenders can reduce cash outflows by suspending coupons.

The market for the notes opened in April last year with a $1.5 billion issue from Banco Bilbao Vizcaya Argentaria SA that paid a 9 percent coupon. The average coupon on the securities in Bank of America Merrill Lynch’s High Yield Contingent Capital index, which includes many of the new additional Tier 1 bonds, is now 7.27 percent.

Yields on the securities soared to 6.87 percent on Aug. 8 from their June 10 low of 5.80 percent amid concern that the economic recovery was flagging and that fighting in Ukraine and the Middle East would intensify.

The average price of high-yield contingent capital bonds has since rallied and is now 102.9 cents on the dollar to yield 6.44 percent, according to Bank of America data. The price fell to a record 99.85 cents on Aug. 8.

‘Cheap Capital’

“For the banks this is still really, really cheap capital,” said Mark Holman, chief executive officer of TwentyFour Asset Management LLP in London, who said he would be “really surprised” if less than another 10 billion euros is issued by year-end. “As investors, we’d like to get broader exposure to a broader range of issuers because we have what we want from banks that have already issued. Bring them on.”

Holman said he’s looking forward to the HSBC deal because it will be large, liquid and is a debut in the Tier 1 market.

HSBC’s bonds gained an expected Baa3 rating from Moody’s Investors Service while Fitch Ratings said it expects to grade them a level higher at BBB. That makes them the first securities of this type to gain an investment-grade rating, which “will bring in a whole new investor base, which is just what the market needs,” Holman said.

Eyes Closed

Investors’ eagerness for the coupon offered by the additional Tier 1 securities may mean they are closing their eyes to the risks, according to Bill Blain, a strategist at brokers Mint Partners Ltd. in London. That is particularly the case in Europe, where Banco Espirito Santo’s demise showed that the links between regulators and stakeholders such as banking dynasties or local politicians are often too close for comfort, he said.

“As a whole, the European banking sector remains essentially unfixed,” he said. “The various reviews might provide a snapshot of where banks are but they don’t make them any safer. The risks remain.”

Roger Francis, an analyst at Mizuho International Plc, estimates deals from issuers including Dutch and Swedish banks, which have yet to sell the securities, as well as from HSBC and Standard Chartered Plc, will boost the market by about 18 billion euros this year.

Some potential issuers will choose to wait for the results of the comprehensive assessment in October, while others won’t be able to sell because of closed periods around third-quarter results, said Donlon at UBS.

Leverage Ratios

That all assumes that investor confidence isn’t shaken by some outside event, he said.

“UniCredit and Santander are issuing now because they can,” said Eva Olsson, an analyst at Mitsubishi UFJ Securities Plc in London. “Enough investors are interested in buying, so the banks that can will issue as much as required.”

Olsson estimates the banks can raise additional Tier 1 capital at about half the cost of equity. She expects issuance to rise by more than 18 billion euros by year-end and it may turn out to be higher, she said.

Banks are allowed to include additional Tier 1 bonds as capital in calculating their leverage ratios. This gauge measures capital as a percentage of total assets unweighted by risk and is currently set at a 3 percent minimum. Regulators use the ratio to prevent lenders gaming capital as a percentage of risk-weighted assets, the other main measure of their vulnerability.

“It makes sense to issue, given it’s so cheap for the banks,” Olsson said. “If you don’t issue AT1, you have to use equity and that’s relatively expensive.”

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