Southern European champs make their mark

After a debut AT1 for UniCredit in late March at least one top tier issuer from each of Italy, Portugal and Spain has tapped the burgeoning Basel III-era market for hybrid bank capital. But with regulatory questions remaining and the ECB’s AQR in focus, further supply from the countries may emerge only gradually. Susanna Rust reports.

Issuers from Europe’s southern periphery have played a leading role in the AT1 craze sweeping through debt capital markets this year, with national champions Banco Santander and UniCredit each making their Additional Tier 1 debuts in March — albeit catching the market in contrasting moods.

Santander’s deal captured the frenzy in the market well. Nearly a year after Banco Bilbao Vizcaya Argentaria (BBVA) became the first European bank to sell a Basel III-compliant AT1 issue, Santander was one of three banks that helped turn the first week of March into the busiest week yet for European hybrid issuance.

It priced a Eu1.5bn perpetual non-call five issue on 5 March alongside an inaugural AT1 for Danske — making it the first time that more than one issue has hit the market on the same day, and doing so after Nationwide Building Society had a day earlier opened the sterling AT1 market.

As such, Santander’s deal was one of a medley of transactions that, in the words of one observer, “blew away any doubts about the momentum in the nascent Additional Tier 1 market”, meeting with strong demand despite the variety of formats and loss triggers.

In Santander’s case, an upgrade by Moody’s, from Baa2 to Baa1, was a welcome development the day before the transaction ended up being launched, as was a recovery in market sentiment after the flaring up of the Ukraine crisis in the Crimea.

Providing for loss absorption via trigger-based equity conversion — the same format used by BBVA and Banco Popular Español — the CoCo drew orders totalling Eu15.1bn, with more than 640 accounts involved.

The deal — which converts to equity if CET1 falls below 5.125% — was priced at 6.25%, the tight end of guidance of 6.25%-6.50% and initial price thoughts of mid to high 6%.

Santander’s transaction completed a round of AT1 capital raising by Spain’s national champions, with BBVA having already priced two deals — its April 2013 landmark, in US dollars, and a euro issue in February this year — and Banco Popular in October having shown the market to also be open to representatives of the country’s second tier of banks.

Further Spanish supply this year is expected to more likely consist of Tier 2 transactions than CoCos, as uncertainty about the full regulatory recognition of AT1 with a write-down format remains unresolved.

This is particularly relevant for unlisted issuers, for whom equity conversion is not an option, according to Avelino Abellás, executive director, DCM at Crédit Agricole CIB.

“Be it on an official or private basis, everyone is waiting for the Bank of Spain to clarify its position on write-down structures,” he says.

Being held up by uncertainty about the tax treatment of a debt write-down is an experience that banks in several other European countries have faced. There are also some jurisdictions where the tax treatment of AT1 instruments of any type is still being clarified, with Germany the latest where tax-deductibility of coupon payments for AT1 instruments has been announced.

While further AT1 supply out of Spain could be stymied by the lack of regulatory clarity, no such impediment exists for Tier 2 issuance and deals of this kind are to be expected, according to Abellás.

“There are no such doubts about Tier 2 and the market is definitely there,” he says, adding that some issuers are also mindful that issuing Tier 2 instruments before making their AT1 debuts could make pricing the latter easier.

BBVA priced the first Spanish Tier 2 of the year, on 2 April, a Eu1.5bn 10 year non-call five transaction that was priced at 255bp over mid-swaps with a 3.5% coupon on the back of more than Eu7bn of orders from over 400 accounts.

Crédit Agricole CIB bank analyst Gwenaëlle Lereste says that Spanish banks will gradually increase their AT1 and Tier 2 issuance to meet regulatory requirements by 2016, and that in the case of Santander this should amount to Eu12bn-Eu15bn.

Abellás says that most Spanish issuers are well capitalised, but also that market conditions are very attractive, which has pushed some issuers to tap the market earlier than one would have expected.

“Most issuance has been opportunistic as the market is pretty receptive at the moment,” he says.

Indeed, those issuers that tapped the AT1 market more recently have benefitted from the expansion of demand for the asset class, fuelled by a hunt for yield. Banco Popular’s AT1, for example, was trading at 16%-17% higher at the time of writing, while BBVA recently priced its euro AT1 in February at a coupon of 7% following its inaugural, 9% dollar AT1 in April last year.

And Erik Schotkamp, director, capital and funding management at BBVA, said that expectations of further improvements partly explained the bank choosing a five rather than 10 year call in its euro AT1.

“We figure that the situation going forward, not only with respect to Spain but also in terms of the credit rating of the group, is on the path of improvement,” he said, “which means that there is no economic sense to lock in current spreads for a period longer than necessary from a regulatory point of view.”

Abellás says that individual banks’ issuance plans could be affected by the ongoing Asset Quality Review (AQR) being conducted by the European Central Bank, although in general Spanish banks should be in a comfortable position as they already went through Oliver Wyman stress tests last year.

“That being said, the AQR conditions are only being revealed bit by bit and it is still a pressing matter,” he says.

Portuguese await AT1 decision

In Portugal no issuer has followed up on a Eu750m 10 year non-call five Tier 2 issue from Banco Espírito Santo in November last year, and investor appetite for CoCos from the country’s banks remains untested. BES’s deal was the first sale of subordinated debt capital from a Portuguese bank in some four years.

Filomena Oliveira, investor relations, at state-owned Caixa Geral de Depósitos, says that there is lot of uncertainty about how the AT1 instrument will be treated by the authorities, including the tax treatment of write-downs, with the central bank yet to make clear its position.

“We know that this is a topic being discussed, but I believe Caixa Geral de Depósitos by a bank to issue the instrument,” she says.

Another source of uncertainty for Portuguese banks is how deferred tax assets (DTAs) will be classified, according to Cyril Chatelain, DCM, capital structuring and liability management at Crédit Agricole CIB.

DTAs are excluded from capital under Basel III, but in Italy and Spain banks received a boost when they were reclassified as claims on the government. Chatelain notes that under the Capital Requirements Regulation (CRR), DTAs are deducted from core capital.

“Phasing-in of deductions may somewhat alleviate the impact on reported solvency ratios,” he says, “but investors’ focus is on fully-loaded ratios and Portuguese banks’ solvency may pale when compared with some of their European peers ahead of the AQR stress tests and as the country’s economy remains weak.”

Chatelain notes that Portuguese bank equity prices fell sharply in January after Portuguese news agency Lusa reported that the Portuguese finance ministry had decided not to allow DTAs to count as government tax credits.

The ministry subsequently said it was still discussing the matter, with an analyst viewing the negative share price reaction as suggesting that “there will be something rather than nothing” for the country’s banks.

Oliveira hopes that a decision will be forthcoming soon, noting it will have an important impact as Portuguese banks hold a considerable amount of DTAs.

Caixa Geral, for one, does not anticipate needing to raise capital, straight or hybrid, this year, according to Oliveira. She notes that the bank has a Common Equity Tier 1 ratio of 7.4% on a fully-loaded Basel III basis, thereby exceeding the 7% minimum requirement, and that this will be boosted by 1.8 percentage points once the proceeds from a sale of its insurance business are booked.

Notwithstanding uncertainty about the outcome of the ECB’s AQR, Caixa Geral considers itself to be in a comfortable capital situation and does not expect to be adversely affected by the stress tests, says Oliveira.

Fitch in December said that asset quality deterioration, the largest risk for Portuguese banks, is likely to lessen this year, pointing out that the Portuguese authorities have been reviewing the banks’ loan books since 2011.

Improved capitalisation should also help the banks with the ECB assessments, according to the rating agency.

“Their core capital ratios were well above the 10% minimum required by the Bank of Portugal at end-Q3 2013, providing a buffer against credit deterioration,” it said.

More recently, the International Monetary Fund in February said that the largest Portuguese banks have robust capital buffers that put them in a favourable starting position for the ECB’s comprehensive assessment.

Caixa Geral had been anticipating potentially needing to issue Tier 2 subordinated capital this year to replace legacy bonds, but following an EBA announcement of a transitional period for banks in countries that are under bail-out programmes it may not do so, according to Oliveira.

As for AT1 issuance, this is not in Caixa Geral’s plans at the moment, according to Oliveira, mainly because of the aforementioned uncertainty over how the central bank will treat such instruments.

Another variable in the supply outlook for hybrid capital from Portuguese banks, according to Chatelain, is how nationalised banks will repay money they borrowed from the government in the form of CoCos that convert into state-owned equity if a predefined trigger is hit.

Banco Comercial Português borrowed Eu3bn from the government on this basis, which is reimbursable by mid-2017. Banco BPI raised Eu200m in capital during 2012 and issued Eu1.5bn in CoCos to the Portuguese government, according to Chatelain.

“Both BPI and BCP have to pay back the CoCos by 2017, with BPI having already paid Eu1.1bn and being left with Eu400m that we expect should be paid back within the next 18 months,” he says, “while BCP is expected to start repaying the CoCos this year.”

Regarding DTAs, Banco BPI in late January identified these as holding the key to an increase of nearly Eu250m in the bank’s capacity to repay state CoCos — on the assumption of a similar treatment to Spain — saying this was the largest of several “opportunities for improving core tier 1”.

‘Paradigm shift’ precedes UniCredit

UniCredit opened the Basel III-era hybrid capital market for Italian issuers at the end of March with the first AT1 from an Italian bank, a US$1.25bn (Eu905m) perpetual non-call 10 featuring temporary write-down as the loss absorbency mechanism.

The Reg S deal came with an 8% coupon, having been marketed in the low 8% range in Asia and then at the 8.25% area, with bookrunners Citi, HSBC, Société Générale, UBS and UniCredit gathering some $8bn of orders for the deal.

That was a far cry from the order books built for the contingent capital transactions that preceded UniCredit’s, when record levels of demand had poured in, but Waleed El Amir, head of strategic funding and portfolio at UniCredit, is happy with the response to the bank’s offering given its Reg S, undated non-call 10 format and a market comedown from heady heights reached earlier in the year.

“I thought our AT1 was absolutely critical because it was the first deal to hit the market after what I see as a big paradigm shift in the market,” he says. “It became clear that order books were inflated, some deals were pushed too hard and didn’t trade well, and then more supply was being anticipated.

“We were very careful in the allocation of our AT1 and it traded up nicely after to demonstrate that it is about quality rather than quantity, so we are very pleased with the result.”

As has been the case for many banks, UniCredit had to wait for clarity on the tax treatment of coupons and write-down as the loss absorbing mechanism before proceeding with its plans for an AT1. This was provided when legislation was passed in December 2013, leaving market dynamics and the issuer’s 2013 full year financial results as the main variables in the CoCo new issue project.

“We could have issued in January but decided not to because we had a view that spreads and yields would come down as the asset class became more commoditised, and then we also had to wait until our results were out,” says El Amir.

These were announced on 11 March, with the group reporting a Eu14bn loss for 2013, a result that El Amir says necessitated waiting for reactions from the rating agencies.

“We waited for the rating agencies to affirm us and then because we felt the market was in decent shape we went out,” he says. “The market had sold off a bit, but we felt that there was going to be more supply and in the end I think we hit the market at a good time.”

One of the hallmarks of the year in bank capital so far has been the development of the euro market, after US dollars having been in focus in 2013. UniCredit, however, opted for a dollar denominated issue, in Reg S format, to get a more challenging transaction out of the way first, according to El Amir.

“Because UniCredit is a complex banking group getting 144A documentation in place is difficult,” he says. “Reg S in dollars is in our view the most difficult trade to do, and because we felt the market was there it made more sense for us to do the dollar transaction first and then in the future a deal in our home currency, euros, which will be easier to do.”

He notes that the Reg S format of UniCredit’s inaugural AT1 meant US accounts couldn’t participate, eliminating some $5bn-$10bn of orders, and that the undated, non-call 10 structure is an investment hurdle for private banks, and that these factors need to be borne in mind when assessing the size of the order book for UniCredit’s CoCo.

“The market has changed and the deals after ours also had smaller books,” he adds. “The market has matured and there is a better understanding of who to give bonds to and who not to give bonds to.”

AQR prep in focus

Fitch believes other banks in Italy, most likely UniCredit’s larger peers, will follow its lead and tap the AT1 market in the medium term.

“Improved investor sentiment towards Italian banks and the search for yield are positive at a time when many Italian lenders are taking actions to strengthen capital,” the rating agency said in early April. “This may open up the Basel III-compliant capital securities market for some Italian banks, to help them meet the markets’ requirement for higher loss-absorbing capital and combat capital shortfalls that might arise from the ECB’s comprehensive assessment this year.”

It noted that Italian lenders are behind other banks in large European countries in issuing Basel III-compliant capital instruments, but that international investor interest appears to have returned for Italian banks more broadly, with Banca Monte dei Paschi di Siena, for example, in late March having been able to price a Eu1bn five year senior unsecured issue.

Improving market confidence could help Italian banks rebalance funding profiles and strengthen capital, said Fitch, and is likely to benefit those banks looking to access equity markets.

Stefano Rossetto, hybrid capital and liability management at Crédit Agricole CIB, says that for small to medium-sized Italian banks the priority is shoring up equity levels, and that hybrid capital issuance, at least in the public market, will likely come in small sizes or at a later stage.

“The urgency is on the Common Equity Tier 1 side, and the economics are still challenging for hybrids,” he says. “Some of these banks have only recently resurfaced on the FIG flow side, so moving to hybrid instruments is more difficult for them.”

The outcome of the ECB’s AQR will be key for this category of smaller banks, he adds, who could be more affected than the top tier of UniCredit, Intesa Sanpaolo and UBI Banca.

According to Moody’s, eight of the 15 Italian banks participating in the ECB’s comprehensive assessment (which the AQR is part of) recently announced plans for capital increases totalling almost Eu8bn. The rating agency said the capital increases are credit positive but that some of the banks may need to further increase provisions as a result of the AQR.

For top tier Italian banks, meanwhile, hybrid issuance would mostly be driven by a desire to optimise capital structures, says Rossetto, with temporary write-down most likely being the standard loss-absorbing mechanism.

“UniCredit, Intesa and also UBI Banca are well positioned on a European level in terms of Common Equity Tier 1 capital and in terms of the leverage ratio,” he says. “For them it is mostly about trying to use their hybrid buckets to the fullest extent.”

Anticipation of asset growth, if any, and the phasing out of legacy capital instruments could encourage the stronger banks to issue hybrid capital, he adds, with better funding levels a potential additional lure.

Simone Tufo, head of capital management at UBI Banca, says that as Italy’s best capitalised bank — as at December 2013 — UBI is not planning any hybrid issuance at the moment.

“We will use our current CET1, which already includes a buffer for a capital shortfall charge, to absorb AQR and Stress Test exercises,” he says. “AT1 or Tier 2 issuance will be more related to the lending growth in the next five years, and will depend on internal capital ratio projections under Basel III, the pricing available and whether a balance can be struck between investor and issuer needs with respect to the structure.”

He notes that following implementation of CRD IV/CRR in January and recent regulatory clarifications “we see full regulatory clarity on the types of hybrid capital instruments available”, although a final decision from the central bank on the combined buffer requirement is still awaited.

In contrast to authorities in the Nordic countries and the UK, the Bank of Italy has not yet introduced public Pillar 2 requirements in the form of additional capital buffers, says Rossetto, making the national regulatory regime closer to the standard CRD IV framework.

Despite UBI not having plans for any hybrid issuance at the moment, Tufo is positive about the overall development of the market.

“Investors’ interest in this new type of debt instruments is driven both by the new regulations, which define a market for this kind of instrument, and by the higher yield offered, which they of course appreciate,” he says. “This will possibly drive more accurate analysis by credit analysts and more accurate pricing of risk, and consequently to an even better awareness of investments.

“I believe that the efforts by the European banking sector during the last seven years to rebuild capital buffers has helped make the growth of this market possible.”