Europe Bank-Debt Tangle to Get Messier With New Notesby
France set to join Spain in letting banks issue Tier 3 bonds
Differing rules in Germany, U.K. complicate price comparisons
Bond investors, already struggling with how to value European bank debt, may soon have to grapple with a new complication.
French lawmakers will next month begin considering a government proposal to let banks issue notes that sit between existing senior and subordinated bonds. The so-called Tier 3 notes will add to the challenges investors face comparing bank debt across European borders, following on from changes to seniority rules in Germany and Italy, as well as capital reorganizations in the U.K. and Switzerland.
Banks are adopting diverse structures because national regulators are following different paths to meet new international standards. The problem in valuing their debt surfaced earlier this year when prices for the riskiest notes collapsed.
“The frustration is that Europe once again is not agreeing on a single structure,” said Rob Thomas, an analyst at T. Rowe Price Group Inc., which oversees about $765 billion worldwide. That may lead to investors “taking shortcuts” in valuing notes, particularly for more-stable banks, he said.
The new standards, coming into force through 2022, will make banks hold more financial reserves so as to shift the burden of failures to investors from taxpayers. Tier 3 notes will help French lenders boost capital levels, because the bonds’ lower risks will make them cheaper to issue than traditional subordinated debt. Credit Agricole SA said May 12 that it may replace some maturing junior debt with the new notes. Spain has already approved Tier 3 bonds.
Other European countries have taken alternative approaches, creating differing risk for investors. In Germany, senior bank bonds are becoming more risky because changes coming into force next year will subordinate the debt below unsecured deposits and derivatives. By contrast, senior bank bonds in France will retain the same seniority as deposits. Senior bonds in the U.K. and Switzerland are different again, as local regulations have led to banks selling notes through new holding companies.
“You have to do your homework.” said Wim Vermeir, chief investment officer at Ageas NV, which manages about 81.5 billion euros ($92 billion) of assets. “If different senior bank bonds have different levels of seniority then it’s complicated.”
The European Central Bank has flagged risks stemming from differing national rules, saying in a February report that a more uniform regional approach would avoid market fragmentation and ease supervision. These concerns could lead to broader implementation of the German model in place of plans for Tier 3 bonds, according to Salvador Ruiz Bachs, a partner at law firm Allen & Overy. Clauses in existing bond contracts may limit borrowers’ ability to introduce new debt classes, he said.
It may also be questionable whether Tier 3 notes will really provide a significant firebreak for troubled banks, according to Jerome Legras, a managing partner at financial-debt fund Axiom. In theory, the bonds will form a distinct level of capital, taking smaller or later losses than subordinated debt, while helping shield senior bondholders.
“In a deep crisis, the probability that the very thin layer of Tier 3 will be exactly the right size to protect senior debt -- and also have a lower haircut than more subordinated debt -- is tiny,” Legras said. Axiom manages about 500 million euros of financial-sector debt.
There may still be demand for Tier 3 bonds as they should be safe enough for investment managers barred from holding risky subordinated debt, said Emil Petrov, Nomura Holdings Inc.’s regional head of capital solutions. That contrasts with additional Tier 1 notes, the riskiest form of bank debt, which slumped industrywide earlier this year on concern that low capital levels could lead to missed coupon payments.
Still, the biggest challenge for investors interested in Tier 3 debt may be deciding how much to charge banks for holding it, given the lack of history and untested risks, said Claire McNicol, a financial credit analyst at Rabobank in London.
“Working out a fair price for something that sits between subordinated and senior isn’t as simple as it might first seem,” she said.