Europe’s Hot New Bonds Obscure Junior Risks With Senior TagBy and
Senior non-preferred bonds take losses before senior debt
Name allows asset managers to include the debt in senior funds
A new type of bank bond is gaining traction in Europe partly because its name obscures the risks.
Banks have sold about 33 billion euros ($39 billion) of debt they’re calling “senior non-preferred”. The label allows underwriters to market the notes to managers of funds that can only hold senior debt, even though the securities can be forced by regulators to take losses in a crisis.
The semantics seem to be paying off as money managers snap up the notes and lower the banks’ borrowing costs with premiums falling close to the same levels paid on traditional senior debt. The new category was created by French regulators to meet requirements that bondholders, rather than taxpayers, bear the cost of rescuing failing banks. Its popularity may be a sign of complacency in a market suffering from near record-low yields.
“The name is a verbal sleight of hand, but it seems to suit both issuers and asset managers,” said Roger Francis, an analyst at Mizuho International Plc in London. “Investors don’t see much probability of the bonds suffering losses.”
Senior non-preferred bonds, which take losses after subordinated notes and before preferred senior debt, have been used by France, Spain and Belgium to meet post-crisis rules designed to safeguard Europe’s financial system. The risk is that notes can be ‘bailed in” if a bank gets into trouble but other European countries are implementing the regulation differently so it’s difficult for investors to navigate Europe’s bank debt market.
Investor demand is so strong for the new notes that the premium has fallen close to levels for traditional senior debt, which doesn’t face explicit bail-in risk. Since Credit Agricole SA issued 1.5 billion euros of the market’s first notes in December, the premium for holding those securities over similar maturity senior bonds contracted to 38 basis points from more than 50 basis points, according to data compiled by Bloomberg.
Investor appetite is already helping banks cut borrowing costs. BNP Paribas SA issued 750 million euros of seven-year bonds in June with a 1 percent coupon, down from 1.125 percent on 1 billion euros of similar notes five months earlier. Andrew Achimu, a spokesman for BNP in London, declined to comment on the sale while a spokesman at Credit Agricole in Paris didn’t immediately respond to a request for comment.
While some analysts call senior non-preferred bonds Tier 3, referring to their position above subordinated Tier 1 and Tier 2 debt, sales wouldn’t be so successful if underwriters used that name, according to Armin Peter, global head of debt syndicate at UBS Group AG in London.
“If you call it senior non-preferred they can buy it; if you call it Tier 3 they can’t,” Peter said, referring to fund mandates. “A good share of investors has that stance.”
The Tier 3 label has negative connotations because it was previously used for subordinated debt that could take losses even before a bank rescue, said Carlo Mareels, a London-based strategist at Mitsubishi UFJ Financial Group Inc. The term has also been applied to notes sold by insurance companies to meet capital requirements.
But the senior non-preferred label also has its flaws. There’s a danger that some investors may not be aware of the risks in the bonds because “what’s written on the tin is senior, so conceptually it has a good taste,” said Filippo Alloatti, a senior credit analyst at Hermes Investment Management in London.
Still, the details are in the marketing documents for the notes, which highlight the risk they could suffer losses. The phrase “bail-in” appears no fewer than 88 times in the prospectus for a recent Credit Agricole note sale. The European Securities and Markets Authority declined to comment on the marketing of senior non-preferred bonds.
“Who buys these should make sure they know what they’re buying,” said Charlie Bannister, manager responsible for bank recovery and resolution at the Association for Financial Markets in Europe, which represents European and global banks. “Banks are making it clear in their disclosures where the bonds sit in the hierarchy of losses.”
The label may suit asset managers. It’s easier to change the label than change investors’ mandates, said Craig Guttenplan, a New York-based analyst at Muzinich & Co. “The senior label is important because many asset managers have funds that can’t take anything subordinated, or have restrictions on how much they can hold,” he said.
Many senior funds, including some run by Muzinich, can’t hold bonds if their language implies subordination, said Guttenplan. Others may decide what bonds they can hold depending on whether the notes are included in senior bond indexes, he said.
All three major index providers include the new notes in their senior benchmarks.
Bank of America Merrill Lynch has always featured them in its senior indexes and will continue to do so, according to Alexandra Fletcher, a spokeswoman for the bank.
Bloomberg-Barclays bond indexes switched them to senior benchmarks last month from subordinated indexes after a consultation with market participants. Ty Trippet, a spokesman for Bloomberg LP, which manages the indexes and is also the parent of Bloomberg News, declined to comment on the move.
While IHS Markit Ltd. includes them in its senior gauges, the firm also created special sub-indexes earlier this year for all senior bank debt that’s subject to losses, according to Sebastian Meyer, manager of the firm’s iBoxx indexes. Markit called the benchmarks “Senior Bail-in” indexes because it wants the risks to be obvious to investors, but still plans to keep them as part of senior benchmarks, he said.
Ratings firms have taken a more critical approach, with both Moody’s Investors Service and S&P Global Ratings ranking the bonds below traditional senior debt. Moody’s refers to the notes as “junior senior” to “remind investors that this senior instrument also has some junior characteristics,” according to managing director Nick Hill. The firm changed the way it rates the bonds last month, but still ranks all of them lower than senior non-preferred notes, he said.
To be sure, some investors are avoiding the bonds saying they don’t compensate for the risk. The premium is too low for notes that are labeled senior and treated like junior, said Matthew Williams, an analyst at Paris-based Carmignac Gestion SA, which oversees 61 billion euros.
“Non-preferred senior should be priced closer to subordinated debt, especially for second, third tier or smaller banks,” Williams said. “We’re happy to sit this one out.”
Since December, senior non-preferred bonds have accounted for a fifth of total issuance by banks in the three countries that use it, data compiled by Bloomberg show. Sales of the bonds in Europe may surge to at least 390 billion euros by 2022, according to Credit Suisse Group AG estimates.
France was the first nation to approve the new category late last year and came up with the name. A spokesman for the ACPR, France’s macro prudential regulator, declined to comment on the choice of words.
Spain and Belgium followed suit and other European Union countries will have to join once a bill on the debt is agreed by policy makers in Brussels. EU lawmakers agreed on their version of the law on Tuesday, paving the way for final negotiations with member states that are expected to begin this month.
“The French came up with the splendid idea of calling something which is subordinated ‘senior’ in order to meet their purposes,” said Alloatti at Hermes. “Banks are getting away with pricing these subordinated bonds as if they were senior.”
— With assistance by Mark Deen, Paul Cohen, Patrick Henry, and Alexander Weber