You can download a pdf of this article alongside further BIHC coverage here.

On 11 December, the European Central Bank proposed simplifying EU banking rules, with its Governing Council endorsing 17 recommendations, addressed to the European Commission, of an ECB high-level task force formed in March 2025. The ECB report tackle not only AT1, but ranges across topics including MREL and TLAC, leverage ratio, and buffers.

The proposals come ahead of a Commission Banking Report due this year, which is set to focus on EU bank competitiveness, but may cover related matters, such as completing the Banking Union, simplifying capital and macro-prudential decision-making, and reducing national gold-plating of regulations. This could put forward legislative amendments for deliberation by the European Parliament and Council.

The ECB’s second recommendation focuses on adjusting the design or role of mainly AT1, but also Tier 2.

“The value added by including Additional Tier 1 (AT1) (and Tier 2) instruments in the going-concern capital stack has been questioned,” says the task-force report. “The degree of going-concern loss-absorbing capacity of AT1 instruments is unclear.”

Two options are cited by the ECB: “enhancing” the capacity of AT1 to absorb losses when a bank is operating normally, which it says could be Basel-compliant and maintain resilience; or removing “non-equity elements” — i.e. AT1 and Tier 2 — from the capital stack — provided that Basel compliance and capital neutrality are not compromised — and either replacing them with CET1 instruments or eliminating them without any replacement.

The ECB itself raises doubts over the latter options of replacement or elimination, due to their impact on bank resilience, Basel-compliance, and capital neutrality.

Analysis by Crédit Agricole CIB on a representative group of 23 systemic banks across Europe finds that the removal of AT1 and Tier 2 would reduce return on tangible equity by 2.3% on average, with the impacts ranging from 1.1% to 3.8%.

“Replacing AT1 and Tier 2 means more CET1, which is problematic because they have very clearly said that any move is supposed to be capital neutral,” says Doncho Donchev, executive director, DCM Solutions at Crédit Agricole CIB (pictured). “At a time when European banks are finally starting to make decent returns, they would face significant impacts, so this option is a non-starter.”

While the ECB report says that the going-concern loss absorption capacity of AT1s is unclear, it sticks to high level principles and does not explain the instrument’s shortcomings in more detail or highlight which features are not functioning to this end, and hence how they could be enhanced.

The most recent guidance in this regard potentially comes from a March 2022 paper, albeit in a different context: an ECB response to the Commission on its review of the macroprudential framework, where the focus was on banks’ avoidance of MDA (Maximum Distributable Amount) breaches for AT1 reasons, thereby hindering them taking advantage of buffers. Three changes were nevertheless suggested: AT1 coupons to be paid only by profitable banks (not only P&L profit, but potentially also positive retained earnings); allow calls only when AT1 replaced with a cheaper instrument; and have only a point of non-viability (PoNV) trigger (i.e. not a 5.125% trigger).

‘Balanced compromise’ proposed

Looking at the historical context of AT1’s development and experience, as well as the various stated aims of any reform of the instrument, the ECB’s earlier suggestions, and Basel imperatives, Crédit Agricole CIB’s DCM Solutions team propose a “balanced compromise” focusing on MDA and other features on coupon payments — partly for the advantages this would bring, and partly because they consider alternative changes either to be unworkable or to be tinkering with elements of the instrument that are already functioning well.

“If there’s real momentum and there’s going to be reform of AT1, the coupon cancellation mechanism should be the focus,” says Michael Benyaya, co-head of DCM Solutions & Advisory at Crédit Agricole CIB.

Beyond reforming the MDA formula, they propose cancelling AT1 coupons in full if a bank is in breach of its requirements, thereby enhancing its loss absorption. This would be alongside supervisory discretion to cancel coupons.

At the same time, coupons would be cumulative, balancing the appeal of the instrument to investors and putting it on an appropriate footing vis-à-vis equity. Donchev notes how banks compensated investors by paying dividends that had earlier been cancelled during Covid.

“The problem with AT1 right now is, if you cancel coupons, they’re lost forever,” he says. “There’s no catch-up element. So what we’re saying is, cancel them more easily, but to align AT1 with equity — the more junior instrument — make sure that coupons can also be cumulative, on a fully discretionary basis.”

Similarly, they propose the introduction of dividend stoppers, or, where these are not possible, intent-based dividend pushers.

Tweaks to the principal loss absorption mechanism (PLAM) — such as oft-discussed increases to the 5.125% level that is now widely regarded as redundant — are possible, note Crédit Agricole CIB’s team, but carry various drawbacks, not least that higher trigger levels are only likely to see banks strengthening their capital ratios to the extent that the new level simply becomes too low again.

Removing it completely and retaining only the PoNV trigger is therefore their recommendation.

“Increasing the CET1 trigger will bring little supervisory value,” says Benyaya (pictured). “The CET1 trigger will never be high enough to be truly going-concern for a G-SIB. And the AT1 instrument needs to remain marketable — we need to find investors who will invest in it — and if the CET1 is something like 15%, no one will buy it.

“We propose removing this CET1 trigger entirely, to simplify the instrument,” he adds. “We believe this would be Basel-compliant, because in their criteria that trigger is not required for equity-accounted AT1 instruments.”

The idea of allowing calls only when AT1 replaced with a cheaper instrument, as previously floated by ECB staff, could lead to unintended consequences, they note.

“Eventually instruments could be issued in such strong markets that they would effectively become perpetual,” says Donchev, “which is a dangerous spiral that needs to be avoided. Issuers can be flexible and investors will judge them by their call policy and act accordingly, with any cost impact not just on one AT1 instrument but the whole capital stack.

“Indeed, they shouldn’t do anything about calls,” he adds, “because the call rules are the one element that has been proven to work.”

Finally, technical elements allowing for debt accounting valued by issuers should be retained, according to Crédit Agricole CIB’s team.

The ECB has said that any changes to AT1s should only apply to instruments issued after a certain date once laws have been updated. Crédit Agricole CIB nonetheless highlight that, should issuers find it appropriate to update their AT1s from grandfathered instruments to those compliant with any new rules, some changes will be possible without bondholder approval — not being potentially detrimental to their interests — but others will not.

“Changes around coupon cancellation may not need any agreement from bondholders,” says Donchev. “You wouldn’t necessarily even need to change the documentation, if it already refers to potential future articles, meaning that the regulators have a lot of freedom to change the law, and then there’s automatic application.

“If they change the trigger level, that would be different. With the exception of one specific prominent bank issuer, such changes would not come within the scope of changes allowable without bondholder consent.”

However, they note that alongside the possibility of incentivising investors in consent solicitations, issuers have the option of other types of liability management exercises, such as exchanges or buy-backs and new issues.

It’s all to play for

The ECB report is seen as the central bank putting down a marker ahead of this year’s Commission report.

The six person task force included representatives of national central banks, including the Banque de France and Bundesbank, but only one official responsible for banking supervision, Sharon Donnery, ECB representative on the supervisory board of the Single Supervisory Mechanism. The Bundesbank has previously been a critic of AT1 and is meanwhile focused on a simplified framework for smaller banks.

The European Banking Authority, which would be expected to play a role in any AT1 reforms, has been a defender of the instrument and stressed the importance of maintaining the status quo. Outgoing EBA chairperson José Manuel Campa this week echoed the regulator’s stance, but also noted that coupon payment-related issues are something that could be tackled.

Critical in deciding the future of the instrument, according to Donchev, could be quantitative impact studies conducted on the basis of any legislative proposals that emerge, which would inform the direction the European authorities may take.

Like the ECB, the Basel Committee on Banking Supervision has said little officially on reform of the instrument. In Switzerland, AT1 are in play amid post-Credit Suisse positioning, while reform is understood to be on the agenda as banking regulation is reformed in the UK, which could influence EU thinking.

Globally, the only jurisdiction to remove AT1 from the capital stack has been Australia, and New Zealand is due to follow shortly.

“But let’s not forget,” says Donchev, “that Australia allowed large banks to replace AT1 with more than 80% Tier 2 and very little CET1. That’s how they made the proposal workable.”

You can download a pdf version of this article here.

Neil Day, Bank+Insurance Hybrid Capital: What can we expect from financials in the coming year in terms of supply, always a key consideration when it comes to the outlook?

Vincent Hoarau, Crédit Agricole CIB: We don’t yet have final numbers, but we are well advanced in our projections. We have calculated the MREL needs of 60 significant European banks that represent 85%-90% of the entire financial institutions space, and it is already clear that, whether you look at it on a gross or net basis, all the supply will be very manageable. Gross supply from these European banks — everything from covered bonds to Additional Tier 1 — is for 2025 likely to land in the context of €550bn, and looking into 2026, we are talking €500bn, so down some 10%.

Drilling down into different segments, pure MREL needs are forecast at around €160bn for 2026, down €40bn versus 2025’s €200bn. MREL redemptions are quite similar, at €143bn this year and €140bn next. So this net supply of MREL funding will be the major change, down from positive €60bn to €20bn — again, completely manageable.

Going down the capital structure, on the Tier 2 side supply will also be down compared to this year — with one caveat: quite a lot of French 10 year bullets issued in 2016 are coming due next year and will constitute a substantial part of redemptions. Nonetheless, gross supply in the Tier 2 space is going to be relatively stable and very manageable.

For Tier 1, we look at what is up for call in the next 15 months or so, i.e. January 2026 to June 2027, and here we have €36bn in AT1 across currencies, of which €15bn has already been refinanced. To the resulting €21bn of gross supply, we add €9bn-€10bn in terms of bucket optimisation and €2bn in RWA growth, ultimately giving us gross supply of some €32bn in 2026, versus €48bn in 2025 and €46bn in 2024.

So the main takeaway regarding supply next year in the FI world is that it looks like it will be extremely manageable, and that is certainly going to further support the bond bullish narrative, at least for financial institutions.

Corporates is a different story. The gigantic funding needs attached to the financing of AI have complex ramifications in the funding dynamics beyond the world of wholesale funding for financial institutions. Acceleration of SRT could also play positively into the above big picture for banks.

François Lavier, Lazard Frères Gestion: Globally-speaking, I agree with your supply expectations in terms of MREL instruments. 2026 should be a big year in terms of redemptions, and thanks to these maturities coming due, we expect the supply to decline substantially.

On the Tier 1 part of the equation, 2025 has been a bigger year in terms of first call dates than 2026, which points to less issuance next year, while banks have indeed already refinanced a lot of Tier 1 securities that are coming up for call next year, so net-net, that should be absorbable without too much difficulty.

Net supply in the Tier 2 segment should be negative taking into account the big maturities we have, including the bullets issued 10 years ago that you mentioned. Tier 2 net supply was forecast to be slightly negative this year and could perhaps end up flat, while we expect next year to be deeply negative.

Hoarau, Crédit Agricole CIB: Spot on. €17bn of French 10 year bullet Tier 2 redeems next year. This is a substantial amount, playing favourably for the segment as we don’t expect that stock to be replaced.

An additional element that justifies a positive outlook for Tier 1 issuance is that the average reset for the bonds that are up for call over the next 15 months is in the context of 580bp. This is quite an important figure supporting the narrative around supply in the Tier 1 market, bearing in mind that we are now in the context of 300bp-350bp depending on the name.

Jérémie Boudinet, Crédit Mutuel Asset Management: Regarding expectations for AT1s and RT1s, something we may see, and which I would like to see, is newcomers to the market finally making an entrance. Monte dei Paschi di Siena, of course, but also maybe the largest banks from Poland, Slovenia and so on. Perhaps we could see the kind of issuer that already has a broad investor base in MREL issues now tap the AT1 market to optimise their capital stack a little more. And in RT1, issuances from, say, Austria and the Nordics to bring more diversity to the market.

Shrut Kalra, Brevan Howard: The financials bias makes a lot of sense to me — it’s indeed quite bullish for bank credit not to have too much net supply, something that has been well flagged. What’s interesting for me is that we’ve come out of a three-year period of very strong tailwinds for credit as an asset class, and that’s about to change. It will be interesting to see the anticipated wave of AI-led financing hitting public and private credit markets, as yields are moving lower — specifically in the US, and I think financials are going to be an outperformer.

I’m a little bit more mixed on the bond bullish narrative. That may get tested coming into next year, and then we’ll see how macro developments pan out.

Within credit, it’s always a question of RV across the matrix, and a lot of these issuers, especially the ones who will come to the public markets, are very high quality — I know there was a recent jitter in some of these names, but when you actually go through the balance sheets, the balance sheet of these issuers is easier to understand most of the time than financials. I think there is going to be enough demand for that type of paper to make the net negative supply look interesting, meaning at the tight end of the range, I’m not sure that you can necessarily go tighter. I think you could go wider in spreads, although you’d expect financials to outperform in that scenario.

Day, BIHC: Maybe we can just take a bit of a step back before delving further into some of those interesting points, to look at how we got to the tight levels we’re at right now, in spite some episodes through the year. Does it make sense where we are now in financials?

Kalra, Brevan Howard: Like I said, there were lots of good tailwinds in the last three years. Rates went higher. There are a lot of people in the world who believe in the wonders of compounding, and so fixed income really had a solid place, with good balance sheets in place. We finally realized European banks are clean. We finally realized that actually rates going up is positive, not negative. And Europe is a place where there’s a lot of demand for fixed income paper. It’s not so in the US, because, of course, the marginal retail buyer is more interested in owning Nvidia stock than they are in owning 5% yielding paper, whereas Europe is quite different. So, in that context, the last three years are easily explained.

Looking ahead, investors need to question the metrics that supported valuations. The one metric that sticks very strongly is that the balance sheet quality within financials is pretty strong, both in the US and Europe.

I would argue, as we go into the AI capex cycle, which I spend a lot of time thinking about, that there will be some bad money spent. Europe does not have AI-related spend, so hopefully it’s going to be in the US, but it doesn’t mean Europe won’t get infected if the AI capex bubble bursts. But thinking about the impact of that spend and if it was done correctly is still possibly something for two to three years from now.

So, it makes total sense where we are coming from. Does that hold? That’s an open question.

Lavier, Lazard Frères Gestion: It’s true that we have some new issuers coming to the market, including some big ones with the AI investment. I would add that while we might not have AI in Europe, we have infrastructure spending. There will be investment in energy and plenty of other things in Germany and more broadly in Europe.

A third element that we have not yet seen to a great extent is M&A. It has not been a big catalyst in terms of issuance, but there is plenty of hope that at some point in 2026, once we have passed the worst of the uncertainty linked to tariffs, we could see more M&A. And as we have seen in the past, each time M&A picks up strongly, it results in more issuance.

So the mix of AI investment, plus infrastructure investments, plus M&A, ultimately implies more supply from corporates in general, eventually leading to some potential spread pressure.

I share your view that financials are in very good shape — there is no doubt about the health of the sector, both in Europe and also the US. But indeed, we cannot escape the overall market; the supply and demand imbalance will have some impact on valuations, at least.

Kyra Guerrida, Crédit Agricole CIB: It’s important to bear in mind the community of investors who are not around the table — i.e. non-specialists on financials — but who have a decent influence on technicals and on spreads.

In Tier 2, we are around the tights versus seniors — even if there has been some slight weakness and repricing in recent sessions — but looking at some technical elements, next year will probably be even stronger. The pension reforms in the Netherlands, for example, are going to have an important impact on flows in financials. And if you look at the Tier 2 space, specifically — focusing more on pure IG-land, on the single-A, triple-B-plus area — at the end of the day yield buyers can get around 3.75%-4% on names like CBA and CaixaBank that have come lately. You can struggle to find such yields on IG corporates in the same tenor (looking at the call date). So while we may be at the tights in the Tier 2 space, these are mitigating factors, so it still makes sense on a relative value basis — even if I can’t say if it will go tighter. Fundamentals are strong and for a generalist population it offers good value for money.

Matthieu Loriferne, PIMCO: One of the key factors why spreads on bonds generally speaking have done so well is also reflected in the very strong performance in the equity market. The fact that the anchor to the entire capital stack, from AT1s to senior and depositors, is up 60% on average this year, and in some cases has more than doubled in value, is a huge contributing factor in my view to the strong performance of AT1s and senior asset classes. Three years ago, barely 20% of the SX7E (Euro Stoxx Banks) was at book value, but 90% of the US market. Today, it is almost on a par, i.e. 90% of each sector trades at or above book value. So there has been a huge rehabilitation — to Shrut’s point, that the equity market finally has come to the conclusion that not only are fundamentals robust in terms of balance sheet, in terms of capital, but also profitability. If you think about the profitability of banks for a second, they are now on a constant leverage basis as profitable as 2007, and clearly the sustainability is a lot, lot stronger because of the 15 years of rehabilitation we went through. So their rehabilitation on the equity market has been a huge supporting factor, for sure.

Day, BIHC: And do you see the performance of or relative value in financials persisting?

Loriferne, PIMCO: I would say profitability will probably come down a bit from where it is today, especially in some of the European floating rate markets, where it is probably too high. But for as long as rates do not go back to anywhere close to or below 1% in euros and sterling, we think most banks can sustain, say, low to mid-teens return on equity, which in turn is very manageable for both credit and equity investors.

Day, BIHC: Julien, you’ve yet to opine.

Julien de Saussure, Edmond de Rothschild Asset Management: I totally agree with what’s been said.

I just fear we are in an unstable equilibrium, because, basically, we hope for rates to stay where they are. If they go up, we know that it will dry up some of the demand, and if they go down, it has an impact on profitability. So if they can stay here, it’s fine.

And the same for spreads: I am not hoping that spreads tighten — although it would probably mean positive performance on an absolute basis, I share the feeling that, with the dynamics of resets, etc, having a whole generation of very tight resets might create problems for the coming years — even though, at the moment, no one cares.

So we all hope for that unstable equilibrium. But history tells you that if you have no margin for error, that’s probably when the unknown unknown happens. So, let’s stay vigilant.

Hoarau, Crédit Agricole CIB: Looking at Tier 2 valuations, in 2018 and 2021 we had a wave of Tier 2 between swaps plus 80bp-90bp. In the secondary market today, stronger names are in non-call fives around the 100bp mark — DNB’s €400m 10.25 non-call 5.25 green Tier 2 that was launched at 130bp in March, for example, is trading close to 100bp. Do we see a world where in 2026 Tier 2 could in primary again cross the 100bp figure, maybe for, let’s say, a strong Nordic name? Even if — coming back to Kyra’s point — the yield complex is somewhere else today: in 2018 swaps were negative and in 2021 they were only just positive, 30bp-40bp.

Lavier, Lazard Frères Gestion: We hope not. But if demand stays as strong as it has been this year and — as we touched on before — we have negative supply, that, at least, gives a strong tailwind to push spreads a bit tighter. And after that, who knows?

Sebastiano Pirro, Algebris: There has to be some differentiation between Tier 2 and senior — one is at zero in case of a problem, the other will have a haircut — and seniors are not that tight, which is what is keeping Tier 2s reasonable. So you would have to have a material tightening of senior before you would have Tier 2 inside 100bp.

Hoarau, Crédit Agricole CIB: If you look at the spread complex today on five years, taking a solid Nordic name, we are talking 50bp-65bp for senior, and 95bp-100bp for Tier 2 in the secondary market on non-call five adjusted, so it’s extremely compressed. I agree with you that senior would have to tighten a lot — or we accept to live with differentials between senior preferred and senior non-preferred, and SNP and Tier 2 that are significantly lower than what we are used to.

Pirro, Algebris: Not necessarily: you should understand that one is structurally subordinated, but perhaps people don’t — fair enough. But there is a material difference between the two.

Loriferne, PIMCO: Also, the secondary market is extremely liquid across the stack, so I don’t necessarily understand the fascination for primary, especially for larger banks. For some of the very large issuers, you have 10-15 bonds to choose from in AT1s, another 10 in Tier 2s, and dozens in seniors, across multiple tenors and currencies, favouring relative value. I get the negative supply picture, but there is still enough outstanding to express one’s view in financials. Also, it would be good to see some discipline on the asset management side as well — don’t get sucked into very tight new issues or compressed subordination premiums.

Gildas Surry, Crédit Agricole CIB: Our house view is that rates will not necessarily decrease in 2026 as the market anticipates, but simply plateau in euros and also in dollars. So those investors jumping on the primary bandwagon expecting to benefit from rates decreasing could be disappointed.

What we are witnessing in the macro space is a tectonic shift in monetary policy from both the ECB and the Bank of England. This was highlighted in a panel in Frankfurt last Friday involving the Bank of England’s Victoria Saporta and the ECB’s Imène Rahmouni-Rousseau.

They were discussing, among other topics, the ECB’s implementation of its new operational framework, as announced in March 2024, whereby they will move away from short term rates being set at the floor of their corridor, in order to have the short term rates instead moving with a higher sensitivity in the middle of the corridor between the deposit facility and the marginal lending facility. Short term rates are thereby expected to move with a higher sensitivity as reserves are being withdrawn from the sector in the last phase of the quantitative tightening. What was very interesting to hear was BNP Paribas group treasurer Nicolas Pillet’s reaction to Imène, saying, well, yes, you are actually withdrawing liquidity from the sector, but beware, you’ve gone down the easiest part of the trajectory, and now we’re going to reach a level where indeed banks may be short of liquidity, and so it may trigger some moves on the short term interest rates path. Taking up Kyra’s point about what’s going to happen with the Dutch pension fund reform on the long term part of the curve, the shorter part of the curve also may be choppier than what we have seen before.

The Bank of England is also moving towards a regime where short term rates are expected to be more volatile, or at least untested, moving from a supply-driven type of liquidity on offer to the market, to a demand-driven one. Saporta released some nice graphs where you see the short term rates moving back to this range they call the PMRR, the Preferred Minimum Range of Reserves.

So we are seeing a shift in the monetary landscape, with an increasing use of repos and away from non-standard monetary operations, where the ECB and the Bank of England want banks to use essentially repos. So no VLTRO, no TLTRO — all the funky stuff from the central banks’ arsenal. They will stick to the standard MRO and LTRO. So any liquidity going back into the system will come from a much more constrained and untested sort of mechanism. That’s something to keep in mind for next year, where we could see some bumps. Saporta mentioned earlier on in November in a recent speech one such bump, when overnight General Collateral gilt repo rates rose to over 30bp above Bank Rate. Some people still have unhappy memories of November 2011 with the experience of dollar funding for French banks. And we could see some weaker banks being caught out by this tectonic shift of monetary policies.

Kalra, Brevan Howard: Do you have an estimate of what it means in terms of liquidity?

Surry, Crédit Agricole CIB: The Bank of England suggested that, based on surveys from banks, the PMRR will be in the region of £375bn, so probably half of where Bank of England reserves sit now as we reach the end of QT. But when you listen to the ECB debating with the banks, it’s clear that it’s very much an untested relationship, where the reaction function of commercial or private banks versus the lender of last resort doesn’t have any sort of history. So you can model a decrease in the amount of liquidity, but at the moment, any path is possible — the ECB’s balance sheet can shrink, or can be stable, depending on how the banks behave. So it’s difficult to anticipate. It may be also take longer than 2026 to play out. But what you can say is that while banks previously considered that the ECB put was not too far in the money, in this new environment the ECB put is probably a bit further away.

Day, BIHC: That’s given us a lot of detail on Europe, but you also mentioned that rates in the US will not be as low as the market anticipates.

Surry, Crédit Agricole CIB: Our expectation is that there will be inflation that will limit the capacity of central banks in both regions from continuing to move lower. Nothing too significant — for example, we expect rates 20bp higher than where the market expects them to decrease to by January.

Day, BIHC: Julien, you spoke about an unstable equilibrium and the downsides of rates going either higher or lower, but what do you expect to happen?

Saussure, Edmond de Rothschild Asset Management: I guess the view is still that rates will go down slightly in the US. Until recently we were of the view that the ECB cycle might be over, but I’m not so sure of that anymore, so we are probably repricing a bit the potential for cuts in Europe. So there’s still the view that inflation is well contained — even though there might be some inflationary angst on the longer end of the curve.

But again, it’s a lazy picture of a bullish environment for credit and probably wishful thinking. It’s not a self-fulfilling prophecy; things can change very, very quickly.

Hoarau, Crédit Agricole CIB: Perhaps it’s a lazy picture, but it may also be true. I think many observers are potentially underestimating some downside risks to growth in France, but also in Germany. It may only be a gut feeling, but if you look at AI developments, the car industry, the momentum around China, the political limbo in France, and so on, I think 2026 has the capacity to disappoint in Germany and France when it comes to macro data. If there is one conviction I do have, it is that the ECB will pivot sooner rather than later. And this is indeed why at the beginning of the conversation I was insisting on the bullish narrative for financial bonds. In terms of assumptions and predictions, the ECB could surprise nicely. Our research view is the status quo by the end of 2026, and I would not be very surprised if at the end of the day in Q2 we move in the opposite direction.

Marc Schoucair, Crédit Agricole CIB: This year you’ve had a lot of volatility in Fed rates, in terms of standard deviation in the money market curve, and you haven’t had that in Europe. Yet, if you look at European credit versus dollar credit, it has not been a function of short term volatility in rates, it has been a function of real rates. And so if you look at dollar rates, like, say, five year-five year real rates in dollars versus real rates in euros, and you chart it versus European and dollar credit, you’ll see that it tracks exactly. So I’m not sure that portfolio managers look at so-called carry adjusted to volatility. And that’s why I’m not sure that a spike of volatility in the short end of the money market euro curve is actually going to change something in terms of how portfolio managers look at carry.

The second thing is, the performance of financials versus corporates has been a function of the curve. In fact, with financials, you’re trading rates, you’re trading 2s-10s. And 2s-10s have steepened, so financials have outperformed corporates. Lately 2s-10s, 10s-30s have been pretty much stable. And if the curve starts to flatten, you should expect financials to underperform corporates.

Surry, Crédit Agricole CIB: The beauty of our sector is that the instruments benefit from rates decreasing, but fundamentals suffer, and vice versa when rates increase. And so you’ve got a sort of diversified play between your instruments and your fundamentals, depending on the rate scenario.

Boudinet, Crédit Mutuel Asset Management: What I fear is that if there is a rates steepening, theoretically, that’s good for the fundamentals of banks, but I’m afraid that it could trigger a spread curve steepening, too. If you have uncertainty and volatility on the long end of the rate curve, that may be detrimental for bondholders. So while it’s true that rate steepening is good for fundamentals, I’m afraid that overall for credit markets, especially the high beta credit market, that could be bad for us in terms of the consequences for spreads.

Day, BIHC: We’ve already talked a little about some of relative value questions when it comes to different instruments within financials, but perhaps I can ask more directly about positioning going into 2026.

Boudinet, Crédit Mutuel Asset Management: I’m kind of bearish. So while I am mainly focused on AT1 and RT1, I would say that you’re better off sticking to the senior parts of the curve in 2026 — again, fearing spread widening across the board.

One exception to this view could be short-dated AT1 bonds, which have the benefit of having very high coupons, very high reset spreads, so to some extent you may naturally be shielded, even though cash prices are very high — so again, you could see some detrimental effect.

But apart from this, I would say that for 2026, short-dated paper is best — meaning from maybe two years to four years. And I’d say you’re better off sticking to defensive names.

Loriferne, PIMCO: It’s true that all the relationships you can think about are very compressed today. High beta to low beta, Yankees to US banks in senior, Tier 2s to seniors in particular. Cash credit curves are relatively flat. So being defensive in such an uncertain environment makes sense.

Fundamentals tend to anchor performance and ultimately the fundamentals of the sector should support financials’ resilient characteristics.

One thing that is interesting is that while the Yankee premium has in general shrunk significantly nowadays — with the seniors of large Europeans versus US names normalised, similarly for Tier 2 — you still have a meaningful gap in AT1. Granted, there are plenty of reasons for that, including regulation and the weaker structure versus the US equivalent, i.e. prefs, but is the premium still justified? We’ll see.

Kalra, Brevan Howard: Instead of trying to pick beta within this financials complex, if you were hungry for yield and really willing to look at solid banks outside of Europe, an opportunity set for me is Turkish banks. There will, of course, be other CEEMEA countries that come through, but we find them a bit less exciting than Turkey. Once we have picked our special situation, we then learn everything we need to about the macro within that country, trying to make sure that we don’t get that wrong.

But if you have the luxury to move outside of the financials space, which I suspect everyone does to a certain degree, you could have loads of opportunity in January. It’s difficult to make a bull case for going long spreads into a big supply technical in January.

The other thing I would highlight is Trump and the Fed next year. I know that we all have our biases in terms of where US rates should be, but the truth is, effectively you can imagine the Fed’s independence being challenged next year, and so it’s going to be a very interesting year in terms of how that policy is set, how much of that is based on fundamentals and actual US economic data.

The US long end rallied a couple of months ago when Treasury secretary Bessent’s paper on how the Fed should be run came out, in particular the thinking about the long end, but I am actually of a slightly different view. I think, as long as it’s within their power, the US isn’t going to allow the 30 year UST to unhinge in any fashion, which means that actually you’re more guaranteed stability of yields in the US.

Regarding the ECB, I’m very open minded. We could be at 1%; equally, we could see growth from the huge fiscal spend. I can see a very nice story to 1%, and I can also see a little pick-up where European banks lend a little more and we finally have some RWA growth, and there could be an exciting story for Europe over the next two, three years.

I actually think US rates may be really boring — and if it does get unhinged, it’s because the US administration cannot control it, which is not a good risk scenario. In that case, we’re not going to be worrying about long end spreads! So I’m quite excited about what happens in Europe.

Hoarau, Crédit Agricole CIB: So you see a world where solid growth materialises in Germany next year?

There is a lot of execution risk in Friedrich Merz’s infra and defence spending plans announced in March 2025. And as and if things materialise in 2026, it will be in terms of announcing how and when. But in terms of execution, this is something for 2027, 2028. So I don’t see how solid growth will or could materialise so quickly in Germany. Even if you can argue that the announcement alone could push analysts to revise upwards growth projections, that would only be visible in numbers in 2027. Recent manufacturing PMI are not great, same for the trajectory of the German trade deficit with China, and the feared shock from this industrial giant may be a story of 2026. Therefore I believe the market is underestimating the probability of additional rate cuts from the ECB.

Saussure, Edmond de Rothschild Asset Management: I agree with you, but it’s still a timing issue — the money is going to be spent — and I don’t anticipate the ECB lowering just for one year. But then there is the question of differentiating between France and Germany, and I think that still makes a lot of sense.

The question of momentum in France versus the rest of Europe is interesting, because French banks are probably less sensitive to rates going down, and you see some margin expansion — unless it’s eaten by the widening of the sovereign. So that’s diverging dynamics against a backdrop where all the axes of risk are compressed.

One of the areas I’m worried about is third tier banks, particularly in southern countries. Some of these have been very late in diversifying away from NII to fees, are not even reaching cost of equity at this point of the cycle — they’re not going to make it when things turn sour. So that’s somewhere we are shying away from. I still believe that there are some jurisdictions outside of the core countries that are more interesting, simpler in terms of profitable banks.

And indeed, we may talk about ‘core’, but there’s no safe haven anymore. You have maybe the Nordics, but then if Russia invades, you have a problem. Switzerland is not a safe haven because you only have UBS, and UBS is probably the bank with the biggest capital uncertainties.

Coming back to France, the supply picture is not easy. Everything has been pre-financed, except France. French banks are probably more picky in precisely timing their issuance. We’ve seen some new insurance issuers coming to the French market. So it’s still a very open question, how the market could react to the potential further development of political uncertainty in France — I think it’s still a fair risk factor going forward.

Schoucair, Crédit Agricole CIB: I love how we’re looking at periphery.

Twenty-five years ago, I started on the Bund trading desk at Deutsche and my boss explained to me how the deliverable on the Bund future would soon be any sovereign in Europe — it could be Greece, it could be Italy. Everything was going to trade flat. And in 2001 BTPs traded inside 20bp to Bunds. That was periphery doing better versus Germany; today, it’s actually going to be Germany doing worse versus periphery, because the Germans are going to be spending. So we’re going to have the same dynamic, just the other way around.

Saussure, Edmond de Rothschild Asset Management: In terms of allocation, we are keen on investing more in Germany for the benefit of potential higher growth. The problem is that the banking industry in Germany has a weird shape, between the cooperative sector, the mutual sector, the smaller commercial banks, the exposure to CRE. Austria is even worse: there’s not one single bank in Austria that is comparable to another. Within the European risk matrix, these are jurisdictions that deserve a slightly higher allocation, but it’s difficult to deploy.

Kalra, Brevan Howard: To context Germany getting worse: they’re going from 60% to 80% debt-to-GDP, assuming no growth. Everybody’s asked them to spend for 15 years running, and now they’re spending money. For me, the bear case in Germany is if Merz is not able to hold on to his seat. If he holds onto his seat, he’s probably the first German politician who’s got some of the ducks in a row to deliver something better than the last 10 years and it will allow spending in the right way, possibly for Europe, too — although maybe not France.

I actually think it would be very good for France if we got a political change. This limbo is costing France a lot more than bringing in someone who’s untested but can deliver a sensible budget with support from the republicans.

When it comes to periphery, they are really used to managing their debt in times of stress. They’ve learned it over 15 years. They actually did really well out of the 2022 situation. Greece, Portugal, Ireland, they all took the medicine. Italy was the only one that didn’t, and actually higher rates are super-helpful.

That said, if there really is no growth in Germany, I would put a question mark against the whole of Europe.

Hoarau, Crédit Agricole CIB: Perhaps I can put on the table some risk factors for next year: swap spread volatility; equity correction driven by AI valuations; weakness in private credit and everything related to the leveraged loan markets; the midterms in the US; and indeed what is going to happen around the Fed. Aside from that, I would say it’s very difficult to see an obvious or potential black swan derailing a relatively constructive scenario for the credit market in 2026. What do you think?

Pirro, Algebris: I don’t need to tell you: you never see the black swan. And the things you mentioned are normally in addition to the one that you didn’t expect. There’s never one thing; there’s three, four, and then all of a sudden it looks pretty bleak. That’s how things sell off.

I am of the view that when spreads are super-tight, it’s just a matter of time… But then again we had the same situation a year ago and this year we haven’t really widened — fair enough.

I would highlight that in Europe, we have infinite liquidity. The ECB hikes rates, but in the end, there is no pass-through, because the management fee on cash is the ECB base rate. There is no competition for deposits, which obviously benefits bank profitability. Last year they made a 4% management fee on cash — this is eight times the one of the average actively managed fund. And doing nothing. There is no competition — especially in southern Europe. Nobody is thinking, I could get a couple billion of new deposits because nobody wants to disrupt this. It’s not normal.

If growth picks up and there are opportunities to lend, then all of a sudden, the whole thing could rebalance. This doesn’t necessarily mean that BNP is going to trade at €150, because ultimately, margins for some businesses may actually compress, if the market were functioning normally. So the ECB is probably keen to restore a market where they raise rates and the transmission channel functions together with loans — currently, we only see it in mortgages, because they don’t have it. They’ve been easing and injecting liquidity into the market for 10 years, and currently they are still at a point where there is no tightness. I don’t know when it’s going to happen — there is no historical data. And now it doesn’t look particularly necessary to tighten in Europe, because inflation is nowhere to be seen. We had a supply shock, we had 10% inflation, with gas prices shooting up. But today, we don’t have that, inflation is pretty soggy. And so they can cut rates — but they are still tightening on the QT side of things. They haven’t found an equilibrium — yet.

The inflows that we get are a reflection of the fact that nobody is able to make anything on their cash. It’s not that, say, Italian institutions are geniuses in manufacturing asset management profits — they’re not; the point is, they are not paying on deposits. So it all comes back to the same thing. You don’t need to be bearish to imagine that spreads may widen. You simply need a lower amount of inflows.

So I think when spreads are tight, they can only widen.

Boudinet, Crédit Mutuel Asset Management: This is so true about the technical aspects and the inflows that we’ve been encountering. What I would add is that we have experienced a lot of volatility shocks, but they did not last long, because everybody was buying the dip. But if we don’t have that kind of technical backdrop, I’m afraid that volatility shocks could last for longer. So I don’t know about the nature of the shocks, but we may have longer periods of uncertainty, of spread widening, and this in itself can change the behaviour of investors, who may then review valuations a lot more than they did in the past few years.

Day, BIHC: The latest shock was First Brands, Tricolor and that whole episode, with Jamie Dimon’s remark about more cockroaches coming out. Do you have any fears of more emerging on this front?

Loriferne, PIMCO: As bank analysts, we are always on the lookout for the emergence of credit risks from within or outside the banking system. Whilst banks have done a very good job at cleaning up, restructuring, etc, they will remain exposed to fraud or bad underwriting risks, as seen over the past couple of months with the examples you highlighted.

If one uses historical precedents, including the most recent incidents, unchecked credit growth, weak credit underwriting and leverage have been associated with increased credit losses at banks.

The key, though, is the ability to absorb that. For some banks that are highly diversified and highly profitable, that’s 1%-5% of their quarterly profit. For some of the more concentrated banks, it can be up to 15% of their quarterly profit.

Are we going to see more of these things? Potentially, as it tends to happen when you have rapid credit expansion. And where has the credit expansion taken place over the past 10 years? It’s clearly outside of the banking system. What will be interesting is, how does it come back to banks? We’ve seen it through securitisation, through lending to those vehicles, whatever they may be. And so I would continue to monitor banks’ exposure towards this rapidly growing asset class and encourage much improved disclosure from banks on this NDFI segment.

Day, BIHC: Turning from the more directly market-oriented topics to capital requirements and the instruments themselves, Michael, what would you highlight as the current developments to watch?

Michael Benyaya, Crédit Agricole CIB: I would first of all highlight the ECB initiative to try to simplify the regulatory framework, with the taskforce due to deliver a report by the end of the year. People should not expect any decrease in capital requirements, because simplification is not deregulation or lowering capital requirements, in the view of the ECB. It will be focused on simplification of processes — reporting requirements, in particular. We may also expect a simplification of the buffer framework, which is super-complex in Europe, with its multiple buffers — systemic buffer, O-SII buffer, G-SIB buffer, and so on. But at the end of the day, one should not expect any lower capital requirements for European banks.

There is also a lot of focus on the structure and the future of AT1. My view is pretty simple, it’s that we should not expect any significant change. I don’t feel it’s the priority at the moment to change the structure of the AT1 product, and given the level of complexity of the current framework and the interplay among the various requirements — Pillar 1, Pillar 2, Leverage Ratio, and so on — for me, it’s not the right time to look at the AT1 structure. Of course, I know there have been some developments in Australia, where they phased it out, and in Switzerland, seeking to amend the structure a little. But as I like to say, these are only one country; the EU, it’s 27 countries. So I think it would be much more difficult to find a consensus around the AT1 product in Europe. Therefore, I don’t feel that we should expect any meaningful change. But happy to hear views from investors on this.

Lavier, Lazard Frères Gestion: Frankly, I share your view, in the sense that simplification is what we could expect, and not so much deregulation, and given the fact that Europe is so complex to make changes. Personally, I have plenty of wishes, but I guess these will remain wishes and not be implemented. To give you an example, I think MDA regulation is excessively complex with too marginal usefulness. We have too many MDA buffers and so on, with different capital ratios. So at the end of the day, we should get rid of it. But I suppose it will never occur, at least for the next couple of years. Maybe in the next iteration of regulation we will see something different, but I also have low expectations there.

Something that is interesting is what the BaFin is pushing a bit in Germany, having a simplified regulatory environment for smaller banks. Indeed, we have it in the UK. Coming back to the point about being paid for deposits and having more competition, simplifying regulation for smaller banks could be good. So let’s see if it goes forward or not.

Boudinet, Crédit Mutuel Asset Management: While Europe is trying to simplify things, in the US they’re going to get rid of the Basel III endgame and possibly parts of Dodd-Frank/Basel III. They may not implement any long term debt requirements. They still refuse to have a proper supervision of their regional banks. In the UK, we have also seen steps towards true deregulation for second tier, challenger banks. Europe will eventually deregulate to some extent, because European banks are going to again lose market share, especially in capital markets, versus US banks, and I think that they will try to lobby for that. But it will take a lot of time, and that’s going to be, again, detrimental for the competitiveness of European banks, for the level playing field. So that’s an issue.

Regarding the Swiss case, I don’t think that markets are correctly pricing the true regulatory and legal risk embedded in what is envisioned for the future of Swiss AT1 bonds, and especially the coupon risk. For the first time in eight, nine years, we may see coupon risk returning to the fore, something not seen since the available distributable items issue for a few German and Austrian banks back in 2016. This has not yet been taken into account. I don’t think that it will pose a contagion risk for all AT1 bonds. Nevertheless, I expect a lot of financial media attention towards that question.

Day, BIHC: When discussing supply, we talked a bit about AT1 calls. Has there been any evolution in issuers’ call management strategies?

Benyaya, Crédit Agricole CIB: The development of liability management techniques has further reduced the likelihood of any non-call event, meanwhile increasing call expectations among investors. The vast majority of AT1 refinancings now have a liability management component, and I would expect that to continue.

This is also a space where we could see more simplification. The process involving the ECB is still extremely difficult and cumbersome for issuers, and I feel that the ECB could massively simplify the LM process for banks to further make it smoother, also for market participants.

Day, BIHC: We’ve mainly talked about banks, but we don’t want to neglect insurance, and indeed there’s recently been a recent flurry of issuance, from France in particular. What would you highlight on this front?

Saussure, Edmond de Rothschild Asset Management: Part of the French issuance we’ve seen is a refinancing of the grandfathered Tier 1s that were issued in in 2015. It’s not only French bancassurance, it’s also the instituts de prévoyance and so on. Part of that flow is also driven by M&A, because a lot of these smaller mutuals have been diversifying their business mix. These guys are only coming to the capital market once in 10 years so they can’t be wrong about when they issue and the picture for French risks is somewhat uncertain at the moment. They’re interesting stories, although they don’t really have much read-across for the wider market.

The development I find interesting in the RT1 space is that it is not confined to the perp non-call 10 format anymore. One of the key problems I had with RT1s was that the perp non-call 10s meant that the allocation to that bucket in risk terms was always super-big. So the fact that now they accept that you can issue perp non-call five, non-call seven smoothens a bit the disequilibrium between AT1s and RT1s. I’m happy about that, because I like the RT1 space, but the duration aspect of it made it problematic to justify in a portfolio.

Benyaya, Crédit Agricole CIB: I’d agree. The RT1 supply was indeed driven by the refinancing of legacy perp instruments, and also probably by the compression between RT1 and Tier 2, which makes RT1 more attractive to insurers. For next year, we expect less insurance supply. Also because the Solvency 2 review will probably result in the release of capital for insurance companies, maybe around 10 points of Solvency 2, so there will be a bit more flexibility.

Hoarau, Crédit Agricole CIB: Going back to valuations, a couple of weeks ago we had an RT1 from Axa and then this week an AT1 from Barclays 100bp or more wider — what is behind such an optically elevated differential?

Pirro, Algebris: Banks are much bigger and much more concentrated in people’s portfolios. You have some pricing power when a name like Barclays comes with its 17th or whatever AT1 and the larger names tend to have wider spreads, to some extent. Barclays is also bracketed with names like Deutsche, at the wider end of the market — it doesn’t make much sense if you look at ratings, for example, but it is UK, with investment banking, etc.

Meanwhile, Axa is much smaller and scarcer. Remember Generali’s really tight effort — you could buy the 30 year BTP with a similar coupon. It made no sense. Insurance is a bit of its own niche.

And structurally, AT1s are weaker. There is also the potential extension, which is perhaps less relevant on an RT1 given the non-call 10 format of most bonds. They also haven’t really been tested. It may be that wider levels are justified for RT1s. But from my perspective, AT1s are more attractive because they are wider.

Ranging across currencies including euros and sterling, the bulk of Canadian supply nevertheless came in the US dollar market, where — on top of a $1.5bn five year CIBC covered bond — some $12bn had hit the market from the country’s banks even before BNS’s three-parter.

BNS approached the market the day after the conclusion of the latest FOMC meeting — with the Fed having, as expected, held rates — and after the release of US GDP figures in the morning joined seven other issuers in the primary market but, as the only core FIG issuer of the day, gaining the full attention of the targeted audience, according to Daniel Kim, director, US syndicate, at joint bookrunner Crédit Agricole CIB.

“We were cognisant of the fact there was combined new issuance volume of over $20bn and Scotiabank was one of the last Canadians in the marketplace,” he said, “but the key consideration was that the market remained extremely receptive to risk.

“Rates had been fairly volatile, but there had been no negatives yet from the global tariff situation, so it was a question of striking while the iron was hot.”

The Canadian bank went out with four year non-call three and six non-call five tranches potentially in fixed and floating rate format, with the longer dated issuance diversifying from the prior Canadian supply and the shorter fulfilling BNS’s needs.

Initial price thoughts were US Treasuries plus 90bp-95bp and plus 105bp area (and floating rate equivalents), respectively, for the 4NC3 and 6NC5 tranches, with a size target of $2bn flagged.

With overall demand totalling some $4.7bn when guidance was set around three-and-a-half hours later, but interest in fixed rate paper significantly stronger, the potential 6NC5 tranche was dropped after just missing the minimum size target.

Levels of SOFR plus 89bp and Treasuries plus 70bp were set for the 4NC3 floating and fixed rate tranches, respectively, and Treasuries plus 82bp for the 6NC5 fixed rate.

BNS ultimately printed $1.25bn and $400m 4NC3 fixed and floating tranches, and a $1bn 6NC5 fixed rate tranche on the back of a $4.05bn final order book.

“Scotiabank could exceed their initial size ambitions,” said Kim (pictured). “After the 22bp-23bp of tightening, book attrition was super-low for the 4NC3 FRN and limited for the fixed tranches.”

Meanwhile, after more than a year’s absence from the euro covered bond market, RBC successfully returned on the Tuesday (28 January) with its such issue since July 2023, and the first Canadian euro benchmark covered bond this year, the last having been a National Bank of Canada four year in October 2024.

The pace of covered bond issuance has been slower than in previous years, partly driven by the collapse in the euro swap spread in the back-end of 2024 — with the 10 year euro swap trading through Bunds — which ultimately led to the market repricing wider, as investors wanted a pick-up versus SSAs. Issuers were also less keen to tap the market, as covered levels became fairly expensive to where they could fund in senior preferred.

However, net negative euro covered bond supply and high investor cash balances to be deployed in primary contributed to a bullish run in the first three weeks of January, with orderbooks multiple times oversubscribed and issuers able to move pricing aggressively from guidance.

These positive execution metrics encouraged RBC to tap the market and build upon the strong momentum, according to Matthew McFarlane, FIG syndicate at joint bookrunner Crédit Agricole CIB.

RBC opened books for a five year euro benchmark covered bond with guidance of the mid-swaps plus 46bp area. The deal enjoyed strong demand in the first hour of bookbuilding, with several high quality triple-digit orders from real money investors. The book peaked at €2.75bn, giving the leads the confidence to set the final spread at mid-swaps plus 40bp and solve for size thereafter. RBC was ultimately able to print €1.5bn from a €2.55bn final book, encountering very little book attrition.

“RBC was refreshing its euro covered curve and despite some idiosyncratic dynamics affecting outstanding covered bond secondaries, which can be illiquid, looking at recent primary supply, the final print of mid-swaps plus 40bp illustrated a zero new issue concession and was well inside the secondary market level of direct peers,” said McFarlane. “The opportunity to buy RBC is rare and the pick-up on offer versus core names was attractive — there was very little pushback from the investor community when we moved to the final pricing iteration”

“Should other Canadian issuers want to come to the euro covered bond market,” he added, “they can expect a similarly positive reception.”

You can download a pdf version of this article here.

Neil Day, Bank+Insurance Hybrid Capital:  André, where do we stand in the FIG market in terms of credit spreads at the turn of the year? What is driving performance?

André Bonnal, Crédit Agricole CIB (pictured): Overall, we’ve had a very strong year for credit in 2024. It has pretty much delivered on the end-2023 consensus. The lower parts of the capital structure have outperformed, with a compression of spreads throughout the capital stack. The main reason credit has been so strong is the liquidity situation and the carry that was on offer. IG credit funds have had pretty much non-stop inflows throughout the year. And in terms of carry, you’ve been getting 3% to 5.5% for single-A, triple-B-type assets that protects you against any kind of mark to market volatility, which is particularly constructive.

Supply has meanwhile been very manageable. Yes, it’s been a record year for capital, but it was exactly what investors wanted to buy, so it’s been very well digested. And if you look at the more liquidity-type funding in euros, covered is down 20% and senior preferred/OpCo 25%, while bail-in debt is up just around 5%. So everything has been perfectly manageable, if not a little bit underwhelming, especially in the second part of the year. We are finishing 2024 5% down year-on-year versus euro supply at the same point last year. That has all been extremely supportive.

On the rates and macro front globally, central banks have delivered on fighting inflation, getting it under control without breaking the economic engine. Some countries have fared better than others, but fundamentally, the macro backdrop has been quite benign and positive for credit.

Where exactly do we stand now? I imagine there’s a difference between how issuers and investors see it, but we are probably almost priced to perfection for issuers. Credit spreads remain at very tight levels in absolute terms — although it may take issuers some time to digest spreads being 20bp or so wider versus September in light of the Bund-swap spread tightening of September, October. On the investor side, versus Bunds we are still pretty much at the tights of the year, so the prospect of further performance is not as strong as where it may have been earlier in the year.

And if you look at risk factors going into 2025, the list is growing. We’ve had a bit of a preview of what the year could present in terms of volatility with the massive decoupling between the US and Europe. The ECB is expected to cut between 1% and 1.5% by June, but the Fed just around 50bp. What impact is that going to have on European banks?

And as we know, the situation in core Europe is particularly bleak from an economic and political standpoint. We are in the midst of a crisis in France and then you get German elections on 23 February. So a lot could go wrong into the beginning of the year — not to mention Trump policies, tariffs and their implications for global growth and inflation in 2025. Eventually here we’re less bullish on credit than we were at the end of 2023.

But overall, it’s important to bear in mind the technicals I mentioned — the liquidity situation, which is still going to be playing out strongly in 2025, and supply, which is not expected to be drastically higher and could potentially even come in a bit lower.

Michael Benyaya, Crédit Agricole CIB: For 2025, we expect similar volumes compared to 2024 overall, but with a change in the mix. We expect AT1 and Tier 2 to be to be down. We’ve just had a super-strong year across AT1 and Tier 2, and part of that was financing of 2025 calls, so volumes will remain elevated, but down compared to 2024. We expect senior preferred and non-preferred to be higher on 2024. Non-preferred will probably be slightly up, but close to flat, because most banks are well positioned in terms of their MREL and TLAC position, and so we have entered the full refinancing cycle for non-preferred and HoldCo. We expect covered bond supply to be slightly up compared to 2024 as we expect loan volumes to resume gradually into 2025.

Raoul Leonard, Sona: The outlook for bank loan volumes and risk weight asset growth is critical to supply. And if everyone is right in being bearish on European economic growth, I struggle to see balance sheets growing.

Jenna Collins, Brevan Howard: But is loan growth expected to be lower or unchanged everywhere? Other than France and maybe Germany, I believe most jurisdictions are expecting a bit of growth, with Spain probably being one of the bigger ones.

Bonnal, Crédit Agricole CIB: Same for Italy. It’s really just core Europe — France and Germany — where, if the overall environment is as stressed as expected, there’s unlikely to be much growth, even if you have the ECB cutting by 1%. That’s why there is probably a little bit more downside to the overall supply outlook than what the forecasts suggest.

Day, BIHC: As André said earlier, the bullish consensus at the beginning of 2024 turned out to be correct. In Crédit Agricole CIB’s latest investor outlook survey, more people are coming down on the bearish side. Jordan, what is your position?

Jordan Skornik, Amundi UK (pictured): I am on the bullish side, at least for the next few months. A lot of negativity is already priced in, but some factors are quite benign. On the supply side, we are indeed not expecting much of an increase. Net supply in 2024 has been relatively low, which is what matters at the end of the day. A lot of deals have already been pre-financed. Of course, in 2025 we’ll have the pre-financing of the following year, but we’re still expecting a very low figure for supply, similar to this year.

We are still seeing quite a lot of demand, a lot of meetings and questions from clients, more than previously. The yields available on these instruments are driving that — if you look at the relative value of a dollar AT1 versus the rest, for example, it’s clear that the yield is the only driver. The inflows we saw this year were quite significant, meanwhile the positioning is quite light, looking at ourselves and our peers. So overall the technical situation looks OK.

There are currently a lot of geopolitical risks — France, Trump tariffs, and so on — but at least for the next three or four months we remain quite bullish on the asset class — also bearing in mind the carry element, which is going to be quite important. Unless you are expecting something really bad, the carry will compensate a lot of the potential short term volatility.

Collins, Brevan Howard: Lately people have been asking how far the compression in spreads can go. And I think we are starting to see where this limit is. In euros, levels are still OK — except, perhaps, for some of the French. Deutsche Bank came at 9%-equivalent in dollars, for example. But in dollars, when Nordea and NatWest came with their AT1s, other five year AT1 were close to 6.5%-6.6%, while the Tier 2s were around 5.8% — spreads down the capital stack are getting so compressed. And you can take it right down to Treasuries — if they are at, say, 4.25%, how tight can JP Morgan, for example, go before you would rather buy a Treasury? I’d say around 5%, so a 75bp differential. Yields are still decent on AT1, so there’s some room for them to rally more, but only if, say, seniors go sub-5% (and Tier 2s under 5.5%). But overall, AT1s aren’t going to go up much more if Treasuries don’t lead the way, so while you can buy them for carry, you won’t really get much capital appreciation. We saw that with Citi’s pref share issue the other day — it came at 6.75% and traded around par. You see it in Asian private wealth — they’re not dumping AT1s, per se, they’re still buying, but less. We’ve also seen second tier names getting close to first tier names, and so there’s little scope for them to go further. Lately when we’ve seen Tier 2s coming close to senior non-preferred for similar credits, you notice that people don’t really want to buy the Tier 2 anymore.

Skornik, Amundi UK: While these AT1 have widened 20bp-30bp in the recent back-up in spreads, you could expect them to widen even further, but they don’t, they’re still trading around par. It shows how important the yield and technical aspects are.

Badis Chibani, Neuberger Berman: AT1s have tightened by around 100bp this year — better than single-B and double-B credit. But it’s still a product to look at for the carry and absolute yield. In a rate-cutting cycle, it’s the best you can get — for the names you’re comfortable with.

Looking at the order books for AT1 in the primary market and Nordea in particular, they were nine times covered — it’s clear how much investors want to buy it, even if the new issue level is low. And there were no new issue premiums on a couple of AT1s this year.

Then if you look at spreads historically and where AT1s are now, they are still not at their tightest levels, even if they have flirted with them. So there are still arguments in favour of the instrument, and even if we do reach the tights, I’m not sure we will stop there.

Collins, Brevan Howard: I think AT1s could tighten in spread. Maybe the reason for the split bullish/bearish vote is that while 2025 might not be the weakest year, it may be a kind of transitional year — better news from some places — banks’ capital and profitability — but we have the sovereign issues. If these sovereign issues recede, that would help. But if they don’t, people may get nervous about some names and stay away from them — although there could be others, such as the UK, that they get comfortable with again.

Leonard, Sona: While we’ve had these big order books for new AT1s since September, the super-tight ones with very low resets have been avoided by the more technical investors, because they’re not as attractive as the AT1 bonds in secondaries of the issuer. We have seen a lot more tourists buying recent new issues. Meanwhile, the street uses these super-tight low reset new issues as shorts. This is quite ironic given we’ve been through a proof of concept in Europe over the last 18 months that nearly every AT1 is called unless it’s under distress. Yet the market is still treating lower resets differently from high resets.

Alloatti, Federated Hermes (pictured): Banks and insurance companies are in good shape — touch wood. Equities are still cheap versus history, and our market is also somewhat driven by the equity market, and we have seen €56bn-equivalent in buybacks.

As has been said, AT1 is a carry product, but unless something unusual plays out — which is not impossible — I wouldn’t expect a lot in terms of capital appreciation. Going back to Jenna’s point, if I had to choose between JP Morgan inside 5% and the Treasury at 4.30%, I’d go with the Treasury, too — also because if there is a liquidity shock driven by tariffs, rates or some other bad news, you should be in the most liquid product, which is the Treasury.

Regarding low resets, I would take the controversial view that the AT1 asset class will haven reached maturity when low coupon bonds are not called and the market just carries on all the same, rather than evoking an end-of-the-world scenario. If a bank or insurance company treasurer has a capital instrument coming up for call at, say, 500bp over and another at 300bp, then it should be their fiduciary duty to call the 500bp one but not the 300bp. It’s not a question of regulatory intervention; just the market perhaps finding an equilibrium over time. (To be clear: this doesn’t mean that I’m short low coupon bonds.)

And then regarding supply, so far there isn’t really an expectation of Basel IV having an impact on capital or loan growth that would justify a positive delta in terms of upcoming supply, and that could potentially be supportive of the market in the coming year, while fund managers will be receiving the cash from calls and LMEs to reinvest.

Leonard, Sona: If we’d had this discussion two weeks ago, in terms of z-spread percentiles versus five year tights, we were getting towards 20th percentile in AT1s in dollars and euros, around 40th in Tier 2 and senior non-preferred, and 50th percentile in senior preferred. But we’ve backed up 20bp across euros and certain dollars, with the French pushing things wider, and spreads now feel more balanced going into January. While we expect lots of supply, you could argue that much of it could go OK — as long as it’s not priced too tightly. So in light of recent spread widening, you could say I feel constructive from here.

That said, there’s clearly a lot of noise. One thing I’m looking at is swap spreads, the widening of the sovereigns. SSA levels, which underpin the market, are making covered bonds a bit awkward. However, everyone seems to dance to their own music in the covered bond world and SSAs, and it doesn’t seem to affect financials people — until it does. There’s definitely going to be some strange pressure between the issuance levels of senior preferred versus covered, if they’re around the same level. If I were a treasurer, I would prefer not to encumber my balance sheet, but rather issue senior preferred to investors who are keen to buy senior preferred — even if it doesn’t actually look great value to me. So I’ll continue to monitor what’s happening to SSAs and covereds, and that’s probably my one concern around new issue pricing.

Alloatti, Federated Hermes: I agree that the SSA widening will potentially translate into our markets. But at the same time, when I ask bank treasuries about these SSA movements, they point out that the new inter-bank market is secured, so issuers are actually doing either self-issued covered bonds with the ECB or pledging the assets, mostly mortgages, with investment banks, for example, and now going out to even three or five years. So there will be less need for them. And if a large European bank were to issue a covered bond at 80bp, I would be very keen to get some on the book. But I suppose they are more likely to issue a senior preferred, at 90bp or even tighter, as opposed to encumbering assets at 80bp.

Collins, Brevan Howard: It’s always a question of when these relative valuations will have an impact, and time and again we’ve seen that it’s when the respective new issues come and they can be compared at around the same time to secondary levels. For example, we haven’t had that much senior preferred lately, which is part of the reason spreads haven’t been impacted yet. I think that when there’s, say, a Santander covered in secondary and a Santander preferred issued, then people will notice.

Bonnal, Crédit Agricole CIB: We got a little bit of that recently when OP did a five year preferred at mid-swaps plus 70bp and a week later Caffil — granted, with the relevant French political uncertainty — did a five year covered at mid-swaps plus 57bp. There will be a lot more of that in January where investors who can easily buy both senior preferred and covered will start to question if it makes sense to buy a very tight senior preferred versus a cheap covered. For the same reason, we’ll probably have issuers not necessarily going into covered if they can do senior preferred at very tight levels and not encumber assets. What they may do is use covered bonds for five to seven year tenors, because we know that long end covered bonds are more difficult and more expensive, and then try to do seven to 10 year senior preferred — also to avoid direct comparisons.

Day, BIHC: France has come up already, and looking at spread compression from a different perspective, with southern Europeans having tightened versus core, what’s next? And to what extent is the political uncertainty in France and Germany exacerbating these dynamics?

Chibani, Neuberger Berman (pictured): This is mainly due to how banks make money in southern Europe versus core Europe: with their variable rates, Italian and Spanish banks have greatly benefitted from the rate hikes, while managing to keep deposit costs low. The French banks have the usury rates law in the country, which limits the increase in mortgage rates, and they also have longer term fixed rate loans. Furthermore, they have been penalised on the liability side, with the regulated savings rates (Livret A) increasing faster than assets and that management can do nothing about. So the Spanish and Italian banks have been performing better on the back of the higher rates. They also face less competition, after the M&A seen in the two countries. In France, there has been no such consolidation, and in Germany, you have maybe more than a thousand banks competing and many of them are not really profitable. So the core and the south are going in different directions.

But indeed, on top of that, you have the political uncertainty. France’s snap election was like the cherry on the cake, with all the volatility it created. I’m slightly bullish on French banks — on their fundamentals — but on French politics, I’m bearish. I think we’ll still be talking about it in six months’ time and we could still see volatility a year on from the snap election in July. So it’s a never-ending game there and I’m not sure what the way out will be.

If you rank the performance of European countries’ sovereign bonds this year in terms of absolute return, the only negative was France, then you have Germany, and the best performing sovereigns were Italy, Spain, Greece and Portugal. And there’s a nexus between the government bond performance and the banks’ bonds in these countries.

Alloatti, Federated Hermes: Yes, you have the different mortgage markets, and also the deposit beta has been much lower in Spain or Italy, which is something that is maybe overlooked.

Then they have enjoyed relative political stability versus, for example, France and Germany. Regarding Germany, they have had a very ineffective government, but a more competent politician could be in place by April, which could resolve the situation in there. Let’s not forget that Germany is one of the few countries that enjoys a degree of the financial flexibility. It also has a very large current account surplus — although it will be interesting to see how that is affected by the change at the White House. The Germans always sort themselves out and there’s no reason why they shouldn’t in 2025.

My wife is French and she has lost hope in France. But nothing has really changed, because we know that in France the solution is always the state. This cannot persist, although, as the joke goes, it will get worse before it gets worse. Maybe at some point in time they will realise that something needs to change. In Italy, the problem was never the Italians, but the political class, whereas in France, there needs to be a change in mentality. The country still a lot of potential. I don’t know if that will take one, two or three years for things to improve, but France is likely remain the sick man of Europe for the next few years.

Chibani, Neuberger Berman: Among German banks, the stress started before the political instability, when the CRE monoliners were hit. Some other CRE-exposed banks were then also hit with a kind of contagion. That’s something you need to bear in mind when looking at countries’ banks, the correlation that exists among them.

Alloatti, Federated Hermes: In the periphery, one of the main cost sources was the non-performing loans, non-performing assets, but that has been repriced down, with the cost of risk being a fraction, in some cases one-third of what it was seven years ago. And of course, this frees up P&L. Meanwhile, especially the retail banking in France and in Germany is more cost-heavy and they are limited in what they can do because they would create social unrest were they were to shut one-third of their branches.

Benyaya, Crédit Agricole CIB: That compression between southern and core Europe has also been seen in the convergence of credit ratings, with many upgrades for banks in Italy, Spain, Portugal and Greece. Now, if you look at across Europe, the rating differential between northern Europe or core Europe and southern Europe is not that big.

Alloatti, Federated Hermes: France could be a catalyst for bouts of underperformance by European financials versus American banks and the rest of the world. But this could create some opportunities, for example if Italian banks widen on the back of French banks widening, as is typically the case, before coming back in.

Skornik, Amundi UK: So far there has been little contagion, whether on BTPs or Italian banks, for example, with OATs and French banks underperforming quite significantly. The questions is whether we will see such contagion at some point.

Collins, Brevan Howard (pictured): To me, France has repriced in a permanent way. It has taken a while for people to understand that — and not everyone has done: we still have dealers saying, France is cheap versus whatever year-to-date. But June 2024 is the new start date. That doesn’t mean it’s a terrible country; it just means it has a new level and we’re not going to go back to where it was before. It is also related to the ratings — although it was quite interesting to see S&P confirm their AA-, at stable, because it looks odd versus Spain, even taking into account France being a much bigger and more diverse economy.

When it comes to Germany, we have to see how much fiscal they want to do, if the debt brake changes. That could also reprice, but German banks already trade relatively cheaply because of their generally lower profitability.

Day, BIHC: We have recently seen large domestic M&A and even cross-border efforts in Europe. Are we finally making progress towards European banking consolidation and unlocking competitiveness?

Chibani, Neuberger Berman: The base case for European banking M&A is a bigger bank buying a smaller one in the same country or in a country it already operates in — so it’s more “A” than “M”. That’s what we’ve seen. There’s been most in Spain — CaixaBank-Bankia,

UniCaja-Liberbank, and the famous BBVA-Sabadell, if it works out.

In Italy a lot of M&A scenarios were discussed: Who is going to buy Monte? How will the third force in Italian banking come about? Then we had last Monday’s surprise news. It’s not surprising that UniCredit would bid for Banco BPM when you consider synergies, market share, etc; it was a surprise because UniCredit was apparently interested in buying Commerzbank.

Even though I want to see cross-border M&A, I am not sure the UCG-Commerzbank deal will work out, because of the political tensions between different countries and the pride of Germans when confronted with the possibility of being acquired by Italians — we’ve seen the negative statements made by the different parties in Germany, the unions and, naturally, Commerzbank itself. Before the BPM announcement, I was nevertheless expecting the Commerzbank deal to go through with a 60% probability; after the announcement, it’s now max 20%. There would be quite a lot of execution risk for UniCredit, because it would be a €800bn bank buying a €570bn bank in Germany and a €200bn bank in Italy, i.e. a bank buying almost the same size. So it’s going to be difficult for them. I don’t know if they can succeed even in Italy, because my understanding is that the government would prefer Banco BPM to buy Monte Paschi.

But net-net, such M&A would be positive for the acquiror and the targets: for the targets, it’s usually better ratings, better spreads, converging with the acquiror; and for the acquiror, it’s a better market share and cost synergies. So both plans have positives.

Given the spread performance that we were discussing earlier, with everything compressed between different countries and different parts of the capital stack, such M&A plays at least still offer an opportunity for interesting trades. We also look at re-rating stories, banks we expect to be upgraded and to trade closer to core names, in senior.

Collins, Brevan Howard: We talk about M&A every year, but I think next year it is particularly likely, because the banks need to do something now that NII is not going up anymore. It’s a story they can tell equity investors. Maybe they held out the prospect of M&A previously, but things were so great that it wasn’t that urgent. Now, they need a new catalyst.

I agree that domestic acquisitions are easier to manage, so maybe that’s going to be the trend. I did have some hope that we might even see that in Germany, because there was talk of Commerz acquiring Hamburg Commercial as a defensive strategy. I don’t know if that was being overly optimistic, because we’ve been waiting on it for such a long time.

Leonard, Sona (pictured): Insurance is also an interesting area in which M&A seems to be breaking out. In that respect, it’s worth bearing in mind the Danish compromise: the loophole that allows a bank to own an insurer, and to then buy an asset manager, and have very low risk weightings across the board.

So there’s just a lot going on. If you’re in the C-suite of any bank or insurer right now, the guy doing M&A is going to be your key guy for growth this year.

I’ve got to say, the UniCredit-Banco BPM deal looks somewhat defensive. It feels like Orcel was trying to stop other deals from happening. Many CEOs haven’t done a deal for many years, so they’re a little bit behind the curve — excluding some of the Spanish banks where emergency M&A has been going on for years. In France, there’s the BPCE-Generali Asset Management tie-up which is actively being discussed. Also, there was the AXA IM deal with BNP acquiring it via its insurance arm, announced in August.

Then there’s eastern Europe. I’m sure there’ll be certain banks trying to scale up there.

Alloatti, Federated Hermes: We always think German and Italy, Germany and France, when we think of cross-border, but eastern Europe is cross-border. With Alpha Bank, UniCredit, for example, got into Romania in a very good deal. Then it’s questionable whether UniCredit-Commerzbank really is cross-border given its largest subsidiary is in Germany — to me, this is a deal to unlock the capital trapped in Munich. Personally, I think they will come back for Commerzbank.

Regarding the Danish compromise, I’d note that the bank’s management needs to demonstrate to the ECB that they actually are integrating the acquisition with respect to liquidity. So it’s not really a free lunch, even if it doesn’t necessarily change how the bank was run. That’s why BNP’s CEO, for example, said very clearly, I want to buy everything without “bank” in the name — and there is the speculation it could look at Ageas, for example, which could be a good fit.

Day, BIHC: What are the expected impacts of the incoming CMDI/general depositor preference?

Benyaya, Crédit Agricole CIB: There are currently various proposals on the table, from the Commission, the Council, and the European Parliament. They all have different views about the layering of deposits. But what is sure is that senior preferred will become more junior in the new liability structure, and junior to all deposits. Depositor preference is almost a given and will be implemented at some point. We can expect an agreement in the course of 2025, and we know that at that point the rating agencies will take actions — they will not wait until the full implementation; they just need to see the final agreement.

In terms of rating impact, most of this will be with Moody’s. For Fitch and S&P, we expect no impact, or a very marginal impact at Fitch in some situations. But at Moody’s, some of the large banks could lose one notch on their long term rating, and also some of them could lose their P1 short term rating, which could be even more problematic, so it’s important not to forget that aspect.

Leonard, Sona: My understanding is that banks can issue more senior preferred to try to support their ratings. My other takeaway is that the senior preferred and senior non-preferred distinction gets blurry.

Collins, Brevan Howard: But they’re not exactly one and the same, though, because senior preferred will be pari passu with derivatives, where senior-non preferred still is not.

Benyaya, Crédit Agricole CIB (pictured): As Raoul said, banks could issue more, but we calculated that banks across Europe would need to issue €150bn more in aggregate to protect their current ratings at Moody’s — that’s quite a lot, it’s not worth it, and we don’t expect that.

Then on the funding mix, as Jenna implied, this will not change, because we expect senior preferred and non-preferred to continue to play specific roles in the liability structure. Senior preferred will remain pari passu with derivatives, so we do not expect to be used for subordinated MREL, which means that senior non-preferred will continue to play a role, used for sub MREL and TLAC.

That’s also why — coming back to the issuance forecast at the beginning — we do not expect CMDI to affect volumes across senior preferred and senior non-preferred. However, my understanding is that some people have a slightly different view.

Skornik, Amundi UK: From my perspective, it will further muddy the waters. When senior non-preferred was introduced, we were sold it as a new asset class, but with the ratings moving closer together, we are going to have two products that are very similar to each other, even if there is the derivatives issue. Is the complication of having the different features still worthwhile? It will probably remain now that it is established.

From a market perspective, although some countries already have this hierarchy, it hasn’t been clear to me there is any pricing differentiation. For example, NatWest’s issuance is different from its peers, but that has never been discounted.

Benyaya, Crédit Agricole CIB: The countries that already have depositor preference will not necessarily be useful precedents, because in those countries it is the sovereign cap that constrains ratings. So I’m not sure that looking at Italian banks will tell you a lot about what could happen for the banks in France, the Benelux, or elsewhere.

Bonnal, Crédit Agricole CIB: So will investors be happy with the 20bp-25bp differential that we have at the moment between senior preferred and non-preferred? Or could it even go to 15bp, 10bp if this goes through and ratings get closer? To me, that feels a bit too close to work.

Collins, Brevan Howard: I think Spain is your guide, because they already have the structure and the ratings probably give you a guide for “new” France.

Bonnal, Crédit Agricole CIB: So we are still talking that 20bp-25bp kind of context, not much of a move.

Alloatti, Federated Hermes: But I think it is inevitable that they will compress, senior pref and senior non-pref. And it should be this way, also because even though they are called senior pref, they are eligible liabilities, so if things go very wrong, they could be impacted as well.

Collins, Brevan Howard: It’s not the same level, though, if it’s pari passu with derivatives, because there would be a difference in desire to trigger derivatives.

Leonard, Sona: I think 8% TLAC gets in the way before you touch senior non-preferred in general, too.

Alloatti, Federated Hermes: But in general, it’s a good thing, because of what happened with SVB. We know some types of deposit are more flighty, and having a level playing field where everyone does the same is better than having to think and dust off the tax code and say, OK, in this country you are preferred, but in this other country you are not.

Benyaya, Crédit Agricole CIB: The countries that already have depositor preference are typically in southern Europe rather than core Europe. However, an exception is Greece, where there is a form of depositor preference, but which is not recognized in the Moody’s LGF model. We could therefore still see an impact for Greek banks, but not in countries like Italy, Portugal or some CEE countries where Moody’s already factors into the analysis the full depositor preference.

Day, BIHC: 2024 was a banner year for subordinated debt, with supply up substantially. Has the market reached an efficient modus operandi with LME and new issues to avoid non-call events? Has investor perception evolved when it comes to call versus non-call?

Skornik, Amundi UK: If someone had in June 2023 asked if all the AT1s would be called in 2024, virtually no one would have said yes. Take the Belfius, for instance: nobody was expecting this bond to ever get called from an economic perspective. And so overall, when you look at what’s coming in 2025, and all the reset structures, who’s expecting anyone not to call? Maybe just RBI or an idiosyncratic name like that.

What they did with these LMEs, the fact that they were done quite far in advance, has been very positive.

However, I would kind of agree with Filippo’s earlier comment, in the sense that there’s always uncertainty over whether something will be considered sufficiently economical or not to be called. I like the US way where it’s quite clear, something is either economical or not, and that’s evident in advance. It’s not like every three years we start to reprice the market because someone says an issuer wants to avoid a call.

But overall, we expect the same behaviour with LMEs next year, which will be quite positive in terms of net supply.

Alloatti, Federated Hermes: There are a few interesting cases coming up next year.

Bonnal, Crédit Agricole CIB: There’s Allianz.

Collins, Brevan Howard: Deutsche Bank.

Leonard, Sona: Definitely, with the FX issue.

Skornik, Amundi UK: There’s the one that they didn’t call in the first place.

Collins, Brevan Howard: So, they might not call it again. But I don’t think it would be a bad move if they didn’t, and I don’t think people would be shocked if that were the case.

Issuers being clearer about how they look at things has helped investors come along for the ride, as we can understand how to look at it, when it’s going to be considered in the money, and when not.

Alloatti, Federated Hermes: Even Santander has moved on from its previous not-so-bondholder-friendly policy.

Benyaya, Crédit Agricole CIB: The regulators gave more flexibility around the use of LMEs, because there is no deduction until you announce to the market.

Leonard, Sona: The situation was ludicrous before, and it was good that they fixed that alongside some other things. The EBA should go further and allow banks to be able to call an AT1 within five years of issuance, subject to regulatory approval — there’s no reason why they shouldn’t.

Skornik, Amundi UK: The LME arrangement is much more welcome than the six month par call.

But whenever the market is pricing bonds very tightly, a new condition that makes me uneasy always appears. Lately it’s the clean-up call. All the recent AT1 deals included clean-up calls at 75% that can ultimately be used to put pressure on investors to participate in LMEs even if they are not that interesting. Most LMEs have been quite OK, but Investec, for example, came a year in advance and at a very high spread, and if they’d had this option to clean up the bonds very easily, it would have put investors in a difficult position. And we had one recently where the issuer tendered the bond at 101.25 but would do the clean-up call at par. Issuers should be careful not to derail this functioning LME activity just because of a few options they get for free.

Chibani, Neuberger Berman: Do you think people will stop buying AT1s if there’s this clean-up call?!

Skornik, Amundi UK: No. No one cares.

Leonard, Sona: They don’t care… until they do.

Alloatti, Federated Hermes: But it’s for the big guys like you to say, no, I’m not in favour.

Skornik, Amundi UK: Clearly I’m not big enough, because I say no, but still…

Collins, Brevan Howard: If it occurs, and it gets in the press, then it will change.

Alloatti, Federated Hermes: To be fair, SEB put it in their presentation. Typically, in the good old days, these kind of things would have been buried in the prospectus, but they put it in a slide.

I agree, it’s annoying, because the idea of the clean-up call in securitisation was 15%, so really just to get rid of a remainder. 70% is not a remainder.

Bonnal, Crédit Agricole CIB: Maybe it will turn out like these three month, six month par calls. A couple of years ago when they were introduced, they seemed like a smart idea, and it’s only really over the past 12-18 months that the topic come to the fore as people have started to wonder if they should be priced to the first call date or the first reset date, given the big gap in valuations. Similarly, the clean-up call is supposed to be a smart idea and at the moment is a free option to issuers, but fast forward three, four years and maybe there will be a question mark over exactly how it works in the context of LMEs.

Day, BIHC: We have seen renewed RT1 supply in 2024. Is the asset class finally on track to achieve more interest from investors?

Benyaya, Crédit Agricole CIB: We have seen an increase in insurance volumes this year, and indeed also an increase in RT1 volumes — which nonetheless remain pretty small in the grand scheme of things. We’re talking new issue volumes for RT1 of around €4bn-€5bn for 2024. That was as anticipated, bearing in mind the end of the Solvency 2 grandfathering period on 1 January 2026.

For 2025, we still expect a good level of activity in insurance DCM, on the back of calls, redemptions, plus the remaining amount of grandfathered Tier 1 to be refinanced. That volume is today around €10bn for EU issuers, so it’s not a lot. And clearly we don’t expect everything to be refinanced in Tier 1, because some insurance companies have the flexibility simply to call with no replacement, or to call and replace with Tier 2. That is fine, and we’ve seen that in the course of 2024. So yes, we expect some renewed RT1 volumes, but we think that the asset class will really remain a niche in the overall FIG DCM market.

Bonnal, Crédit Agricole CIB: It felt like it was only really the Allianz RT1 previously, so it was positive to see a little more, and particularly good for the asset class to have another liquid benchmark from one of the top insurers in the form of Axa’s RT1.

I’ve been hopeful that there could still be a bit more.

Chibani, Neuberger Berman: As Michael said, it has been busier this year, with RT1s €5bn issued out of €22bn of total volumes outstanding. It’s still a very small market if you compare it to AT1s. You won’t have the same liquidity anyway. But the fact that you had some inaugural RT1s, like Groupama, increases interest in the asset class and we will maybe see more demand from investors. But I agree, it’s still a niche market.

Day, BIHC: Is the next test for the asset class upcoming Allianz RT1 calls?

Bonnal, Crédit Agricole CIB: Actually, it kind of feels like this Allianz test is coming a bit too early for an asset class that is just finally getting a little bit more liquidity.

Chibani, Neuberger Berman: It could be a test, given Allianz’s stance vis-à-vis subordinated debt in general. Going back to 2022, they did not call their fixed-for-life Tier 2, they had always said that you have to look at that bond on an economical basis, they then didn’t call it, and the bonds lost 20%. So I think this RT1 with a call date in November next year falls in the same category… So far, it’s okay, it’s in the money, but if between now and November there is more volatility and it’s priced out of the money, I don’t expect them to call it. Which is fair, I think, because for this type of market, RT1s and AT1s, you expect the issuers to make economic calls. The problem is that for one issuer an economic call is maybe 50bp out of the money, and for others it’s 100bp, or maybe 150bp. I would say Allianz is on the more conservative side in comparison to others.

Skornik, Amundi UK: It’s difficult to say, because with the Tier 2 they didn’t call, the gap was huge.

We don’t know what they would define as economical. Is it going to be 5bp or 25bp or 50bp? Probably today, if they were to come to the market in dollars, they would issue at 250bp, maybe 260bp with the recent back-up. The reset on the one callable next year is 300bp, so that should be fine — even if there’s a bit of volatility, they should be able to issue if they want. But the other one with a 210bp reset, if they can issue at 250bp, is it economical? It’s not like there’s 200bp of economic incentive to call and it obviously makes sense to do so. Even with what they have said, if it’s 50bp, they might not call it, wanting to preserve market reputation — which shouldn’t be a factor.

The bank — one of the leading financial institutions in Chile and Florida — held investor meetings with over 50 accounts in New York and Chile on Tuesday and Wednesday, building on work done around a $500m debut in February with a credit update.

Initial price thoughts for the perpetual non-call 10.25 Reg S/144A issue, expected ratings Ba1/BB+ (Moody’s/S&P), were then set at the 7.875% area, taking into account feedback and the issuer’s secondary AT1 level, and with an encouraging $300m of indications of interest.

Demand peaked at $1.75bn, including triple-digit orders, allowing for pricing to be tightened to 7.5%, roughly flat to fair value, and for the target size of $500m (CLP466bn) to be achieved, while the reset spread was 375.6bp, relative to the context of 325bp-350bp for European banks.

The final book was $1.45bn, taking in emerging market and crossover investment grade buyers, given the high double-B ratings, and including international accounts alongside Chilean and other Latin American investors.

BCI’s $500m debut in February inaugurated the international market for Chilean AT1s and its new issue is the third from the country, with Banco Estado having issued a $600m deal in April.

“Three highly successful AT1 deals in the space of nine months are the crowning achievement for more than five years of hard work by the Chilean banks, government and regulators to introduce Basel III and AT1s in Chile, and a testament to the sterling reputation of the country’s banks in the international debt capital markets,” said Doncho Donchev, executive director, DCM Solutions, Credit Agricole CIB, joint bookrunner for the new issue and for Banco Estado’s AT1.

Last Sunday it became evident that Emmanuel Macron had not learned the lesson that French presidents would be wise to avoid the miscalculation of Jacques Chirac — as portentously flagged by Crédit Agricole CIB economists back in 2021 — when he dramatically set France on a course that has left large parts of its population, neighbours and financial markets fretting about the future.

With the Rassemblement National (RN) coming first with 31.37% of votes in European elections, and Macron’s centrist Ensemble coalition on just 14.6%, the prospect of defeat for France’s traditional parties by the far-right RN after first and second rounds of voting on 30 June and 7 July, respectively, is likely, according to Valentin Giust, global macro strategist at Crédit Agricole CIB.

Indeed, his central scenario is a substantial majority for the RN, with an absolute majority only just shy of being the base case.

“There are unquantifiable factors and uncertainties — voter turnout, candidates who drop out of three-way races, correlations between first-round scores and second-round gains — that mostly create upside for the RN in terms of the final results versus the central scenario,” he says.

This is despite early polls not reflecting the factional manoeuvring that occurred this week and thus being of questionable value, not to mention the unprecedented political backdrop. For example, it has been suggested that Macron had expected to benefit from the left being dispersed, as was the case in the European elections, but its parties have quickly coalesced to form the Front Populaire bloc, whose combined European vote share was ahead of Ensemble.

As well as flagging this miscalculation, Louis Harreau, head of developed markets macro and strategy at Crédit Agricole CIB, is sceptical of suggestions Macron was seeking to lay a trap for the RN by calling an election it could realistically win. The argument is that the RN would struggle to maintain its popularity in government, leading to a loss to Macron’s party in 2027 presidential elections.

“We have our doubts about this strategy, to be honest, as it would mean that Macron hopes that France would be in a dire situation in three years’ time,” says Harreau.

The prospect of the 2025 budget facing a no-confidence vote in September and impending general political gridlock are deemed the most practical reasons for Macron’s gamble. But markets are now faced with pricing in a RN budget and considering whether the president’s purported prediction may come to pass.

Based on the economic platform it put forward in 2022 presidential and legislative elections, but taking into account the current context, Giust and Harreau reckon that an RN programme would imply a spending hike of around 2% and fiscal relief of more than 1% of GDP, with some one-offs adding to the deficit in its first year. They calculate that, if fully implemented, it would result in deficits of 6%-10% of GDP per year over the next five years, pushing French public debt towards 128% of GDP by 2028.

“Cautious conclusions should prevail due to the very limited visibility on RN’s economic priorities as well as its future leeway to enforce them,” says Harreau. “In addition, the latest speeches by RN leaders point to a need for fiscal consolidation and call into question some measures, e.g. pension reform.

“A few key measures could offer RN a substantial political return at a manageable budget cost (i.e. below an additional 1ppt of GDP per year of deficit),” adds Giust. “Of course, these projections are subject to extreme caution, not only because of the action of the government, but also because of the change in the economic outlook and of the potential change in the cost of debt.”

Giust and Harreau nevertheless warn that RN’s economic programme, if implemented in full, is likely to significantly increase doubts around France’s ability to sustain its public debt.

“This situation would have the potential to trigger significant tensions on French assets — and some European assets.”

While acknowledging that the RN could adopt a more pragmatic stance in light of this, and also to set itself up for the 2027 presidential election, they highlight the potential hit to France’s funding costs and potential knock-on effects.

“In this context, the uncertainty regarding France’s public finance outlook will remain extremely high until the election, but also until the new government — if it is an RN government — shows how it intends to govern: in line with its promises or with pragmatism.”

Clarity on the RN’s ambitions should develop after the campaign officially starts tomorrow (Monday). The new National Assembly is scheduled to gather on 18 July, with a new prime minister potentially in place in time for the start of the Paris Olympics on 26 July.

The calendar may be turning from 2023 to 2024, but many of the questions stay the same. When do rates start falling? How might CRE hit banks? What future AT1? To discuss these and other critical matters, on 13 December, Bank+Insurance Hybrid Capital and Crédit Agricole CIB invited investors and the European Banking Authority to explore the key macroeconomic and structural considerations for financial institutions issuance in the coming 12 months.

Participants:

Please click here to download the roundtable in pdf format.

Neil Day, Bank+Insurance Hybrid Capital: Inflation and monetary policy have dictated market direction in 2023. Will 2024 be more of the same?

Vincent Hoarau, Crédit Agricole CIB: Looking back a year, in December 2022 markets were expecting the first rate cut to be in late summer 2023. Clearly the reality was completely different. Only a few weeks ago, in October, the market suffered an ongoing increase in the term premium on US Treasuries. So to answer your question, everything can happen and we are in for another wild ride when it comes to monetary policy in the next 12 months.

Central banks have certainly made tremendous progress in cooling inflation — this is what has fuelled the recent phenomenal rally in credit, in rates and in equity. But we are not there yet. Yesterday’s US CPI signalled a bumpy road ahead regarding when the inflation target will be reached. Based on the latest GDP figures and job data, the US economy continues to cruise at a very high altitude. In Europe, the situation is completely different — economic datapoints are weak, particularly in Germany. Indeed, there is a narrative whereby the ECB could be in a position to cut rates before the Fed. But we have to bear in mind that, in contrast to the Fed, the ECB has a single mandate, which is price stability, and we are by no means at the 2% inflation target yet — the next print might be back around the context of 3%, taking into account some base effects that are perhaps not at the forefront of everyone’s minds.

When it comes to the US, following the latest CPI and NFP figures in recent days, if we have a similar set of reports again, we will potentially see markets significantly repricing the rate curve in Q1. That’s one of the main risks for markets in the early part of 2024. Our economists do not believe the Fed will be ready to cut rates before we see a series of negative non-farm payrolls — clearly we are not there yet and the earliest this could potentially happen, according to our colleagues, will be summer 2024. So we have a much more hawkish view with regard to central bank action in 2024 versus what the market is currently pricing, which is a first wave of rate cuts as early as March or April. This sounds a bit like science fiction, particularly if we look back at what happened over the past 12 to 15 months. To me, the extremes would be anything from zero to as many as six or seven rate cuts — again, everything is possible. If we try to sequence 2024, H1 is potentially going to be a repeat of H2 2023. H2 2024 is very likely to be more critical, in the sense that the rate cut cycle will very probably have started, together with a negative equity-bond correlation that can obviously be tricky for markets. Quantitative tightening will be well underway — unless we have a serious credit event or market shock in the first half.

In any case, bondholders are much better positioned going into January 2024 than was the case in January 2023: we have reached peak rates. The worst that can happen is a long plateau, with rates staying at relatively high levels for quite some time, but monetary tightening is definitely behind us.

So I’m quite convinced that when it comes to the primary market in the early days of 2024, people will be chasing highly rated and quality longer-dated paper to avoid ending up chasing such bonds in the secondary market in Q1. We are therefore quite constructive. The carry is great and it’s very likely going to be a year of good capital gains — however, it will definitely be another chaotic year, because rate volatility will remain intact.

To complete the picture, maybe just a few words on what central banks still have at their disposal in the toolbox to decrease excess liquidity. We all know that they, and particularly Christine Lagarde, feel committed to doing this, and it will be important to carefully monitor when the ECB will stop the reinvestment of redemptions under PEPP — the last active asset purchase programme — as well as the evolution of the ECB and Fed balance sheets. Nonetheless, reducing excess liquidity remains a great challenge for the ECB.

Raoul Leonard, Sona AM: In this context I would note that 2024 sees an election cycle where 60% of the democracies of the world are going to the polls — including most importantly the US, of course. It’s going to be a politically-charged environment, and if the US is going into an election with the economy strong and fiscal spending at super-high levels, and everyone is trying to buy votes and to avoid recession, that raises the question whether or not the Fed will go ahead and cut into that. That makes me a little more bullish on the market, although it could mean rates staying higher for longer.

Filippo Alloatti, Federated Hermes: Indeed, it seems that the bond market is finally believing we have peak rates — having been wrong five or six times over the last 18 months. And I agree, there are forces that speak in favour of disinflation. When we consider what could derail this process — and noting Raoul’s point on the politically-charged year — it is a potentially unexpected increase in demand, either in the US, the UK, or even mainland Europe, for whatever reason — governments spending their way into the next election, which is typically the case, or because people realise that the so-called cost of living crisis is not as harsh as they were expecting it to be, for a number of reasons, because mortgage rates are coming down, because house prices haven’t collapsed as was forecast, and maybe because parts of the population abandon the sort of pessimism that took hold over the last 18 months. And then there is the price of oil and gas. Last year, potentially big increases were anticipated, but this year oil prices dropped. This could, however, put pressure on OPEC to do something more radical in terms of supply — the market has always focused more on demand, anticipating a bigger or smaller slowdown/recession, but we should not forget about the supply side.

Jordan Skornik, Amundi: We could also get a positive demand shock, because real wages are back in positive territory. Consumption has been very resilient over the last year thanks to savings. And in the UK, for example, we have just seen mortgages increasing again. I think that the last bit of inflation is going to be probably the hardest to tackle. So while the market is pricing in quite a lot of cuts, it feels like we are going a bit too far, a bit too fast. We can feel there is still a lot of tension on this front — every data point gives some food for the doves or for the hawks — so I suppose this volatility will still be apparent for some time yet.

Jenna Collins, Brevan Howard: I think issuers are worried about the second half, and that’s why we’ll probably see a good amount of issuance in the first half. We may make it to this no landing type scenario, but if we do get a recession, it’s probably going to be more apparent in the second half of the year. But given that everyone’s expecting something to happen in the second half, my guess would be that it will actually happen in March, like this year, or in early 2025.

Hoarau, Crédit Agricole CIB: Some issuers give us the sense that they are already looking into 2025 in terms of funding redemptions, so we may end up in a situation where many are trying to finish full-year 2024 funding plans no later than the summer before starting pre-funding 2025. I believe refinancing risk is a potentially serious topic for the year ahead — but not the early part, where we are very well positioned for the first half of 2024.

Day, BIHC: How do all these dynamics affect your positioning?

Collins, Brevan Howard: Going back to basics, why do we buy credit? Because it offers a pick-up to government bonds. Well, government bonds have come down in yield, so for now, and probably for the first half of the year, the implication is that you’re supposed to buy credit, you’re supposed to go down the capital structure — in good names — and we will probably have a continuation of the compression theme. To put some numbers on it, if Treasuries are at 4%, low 4%,and Santander AT1 are 9% or high 8s, I think you’re supposed to buy the Santander.

Regarding the economy, there is some evidence of a slowdown, but not much, and not in the US. So there’s this push and pull, as Jordan mentioned. And there’s a somewhat controversial view: what if we saw the mini recession in 2022, with demand then increasing again — because of the support of low petrol prices — but then maybe there’s a bigger recession is coming? We’ll see, but for now rates are kind of leading the way, so take duration, moving down the capital structure in banks with good profitability; you don’t need credit protection right now, because we’re not seeing evidence of a downturn yet, but I don’t want to be caught in low quality, low profitability banks.

Skornik, Amundi: But most of us here are credit investors; if you are just a duration guy, would you still be long duration from here? I’m quite happy to buy the all-in yield in the credits, but if I took just duration, I would be a bit cautious — tactically, at least for the next two or three months, maybe I would reduce duration a bit. But given I’m long credit, I’m quite happy to hold the duration — with a bit of protection; as maybe we don’t need protection, but you never know.

Alloatti, Federated Hermes: Just because it has gone so fast over the last month and a half?

Skornik, Amundi: We are pricing in so much for next year. Even as a relatively dovish house, what we are expecting is what is priced in by the market now.

Collins, Brevan Howard: I totally hear you. But this is a very consensus view, that we’ve come too far.

Actually, even though US Treasury yields came down from 5% in October, if we go back to, say, June, July, we were sub-4%. So I’m not saying we can go a lot further, but we can definitely go sub-4% in the near term on the 10 year. We’ll see what happens after that, but post-SVB we thought we were in a worse state, wondering what the repercussions would be, and now we feel a lot better.

Michael Roper, PGIM: If you look at an index level where, say, the dollar market is from an IG perspective, there does come a point where it feels like credit spreads are quite tight. Everybody’s got on this soft-landing narrative, but there are definitely tail risks out there. Perhaps people will start thinking in terms of all-in yield, and the percentage of that which is actually the credit spread, and ask whether they are being appropriately compensated for those risks — even though it feels like the duration point is still something people want to get on board with.

Skornik, Amundi: Buy subordinated versus the rest?

Roper, PGIM: I think that’s where the AT1 world is. In terms of spread, there’s still a conversation to be had, but as you go up the cap structure or into something offering more security, the all-in yield argument is a bit less obvious.

Skornik, Amundi: On the sub strategies, we are remaining very long down the capital structure, but on the main global corporate strategies, we are reducing here and there.

Alloatti, Federated Hermes: Taking not the 100 year view, perhaps, but a 16 year view: since the global financial crisis, the idea for the average European high yield manager has been to buy duration, no matter what. It probably worked well until March 2021. Rates volatility may have subsided, but it’s still there. In November, the only volatility that increased month on month was rates. I get your point about going from 5% to 4%, because Yellen misled, so to speak, investors in terms of the Treasury programme, and the macro data was the same before and after. But I think you maybe want to be a bit tactical in terms of duration: if you think it’s gone too far too fast, then maybe cut a bit, and wait for the next leg up before buying some more.

Leonard, Sona AM: Supply last year was obviously quite short, with everything being tighter and tighter, then we saw the first 10 year issuance coming in senior in November, and it’s done very, very well. I don’t speak for insurers, but is there a part of the investor base that is lacking that product and therefore quite happy to buy quite a lot of it in early January? Not that I particularly like duration, because we’re in a very fickle market, but my suspicion is that some of that supply will be well received. I’m particularly watching the covered bond market, which has been going through some massive palpitations — the reality is, the covered bond market has not been working in the way it should since the biggest buyer, i.e. the ECB, stepped out in July.

Alloatti, Federated Hermes: Would you say they are very cheap at the moment, versus the senior stuff?

Leonard, Sona AM: Yes, I would agree with that, but there are no buyers apart from bank treasuries, and with every new issue they’ll say, make it 5bp wider than the secondary market, which doesn’t really work anyway, so it’s a fake price. It looks like, come January, supply’s going to be quite big in the covered bond world, and no one’s quite sure how to absorb €170bn of new benchmark issuance next year when it’s just bank treasuries and maybe some faster money starting to look into it. Issuance has only been up to five years and I suspect they will try seven now. But if that doesn’t work, and they go back to maximum five years again, against the average duration of their books that’s not a healthy underpinning for the entire capital structure of the banking sector.

Hoarau, Crédit Agricole CIB: Actually what we see in continental Europe is that appetite for covered bonds from pure real money across jurisdictions has been expanding significantly over the past 12 months, to some extent offsetting the decrease in demand from bank treasuries, particularly German bank treasuries, which are not necessarily liquid for other specific reasons, namely concerns around MRR and deposit outflows.

Regarding investor appetite for senior supply at the long end of the curve in January, indeed, I’m very bullish. I fully agree with Jenna that you don’t want to be caught in low quality names, but I suspect that everything that is relatively highly rated in senior preferred or senior non-preferred format in the 10 year maturity is going to be very well received in January — obviously as long as it is priced correctly. There will be a kind of fear of missing out, which will support bookbuilding and primary market execution, particularly for prime European banks that aren’t going to be coming with a 10 year benchmark in euros every day. Dollars is a different story, because people will tend to be more bullish on duration in euros while still having a short bias when it comes to US dollar assets.

Roper, PGIM: The Crédit Agricole senior non-preferred issue that came at the beginning of that 10 year supply was welcome, in that the market wanted 10 year paper from a quality bank. The only pushback is when you look at the spread versus where Crédit Agricole senior preferred might have printed: notwithstanding how well it was received, is the market appropriately charging for non-preferred versus preferred?

Hoarau, Crédit Agricole CIB: If you look on an historical basis, the differential between senior preferred and senior non-preferred has been anywhere from 20bp, 25bp to 50bp, and indeed, in the current market context, it was 25bp-30bp, so potentially at the tighter end of the range.

Roper, PGIM: And when you look at spread curves, Crédit Agricole has issued a 10 year at a similar spread to where it would issue a six non-call five. Again, it’s this preference for duration, but on a spread curve basis, it’s very difficult to want to go out the curve versus sitting in the belly in terms of what you’re being paid for the credit risk.

Hoarau, Crédit Agricole CIB: I hear you, and the 135bp spread for 10 year senior-preferred made it a great trade for the issuer on a re-offer spread basis. But it was also a great trade for investors: people were already in a mood where they are trying to lock in decade-high coupons on 10 years — a record 4.375% in SNP in our case, it was in green format, and it’s trading 10bp inside re-offer. Everyone is happy.

Collins, Brevan Howard: Following up on what Michael was saying, even though I mentioned earlier that I generally like duration, my general view is more that of compression. I think people would go crazy for something like a Deutsche 10 year — it’s not a bank people love, but they don’t hate it; it never issues that kind of deal; and it would be super-cheap. Or a name like CaixaBank. That’s the kind of thing that will do really well — at least in the beginning part of the year. It goes back to the question of what we are getting versus government yields: if you’re looking at something that’s at a very low spread to government bonds, why not just buy the government bond?

Day, BIHC: Michael, what is the outlook for funding volumes?

Michael Benyaya, Crédit Agricole CIB: Looking at public issuances from European banks across all currencies, in 2024 we expect a broadly similar picture to 2023 in terms of total volume, but with a change in the product mix.

Starting from the bottom of the capital structure, we expect an increase in AT1 volumes. This will mainly be driven by the refinancing of calls in 2024 and the first quarter of 2025: we calculate there to be around €40bn of AT1 calls during this period. We therefore have an estimate of around €35bn of AT1 being issued in 2024.

For Tier 2, we expect volumes to be flat on this year, or perhaps a slight increase. The Tier 2 market has been broadly stable year on year over the past years, always around €30bn-€40bn euro-equivalent, and it will remain the same in 2024. All the banks are pretty well optimised in terms of the Tier 2 bucket and it’s just a question of maintaining this — we don’t really see incremental needs.

We actually expect a decrease in senior non-preferred/HoldCo volumes, of up to 20%, to around €150bn. This may seem quite a lot, but if you look at the vast majority of European banks, all of those that had the 2024 MREL target, they are they are well optimised in terms of MREL, having built up strong buffers to minimum requirements, subordinated and total MREL. Therefore, our feeling is that the senior non-preferred market will switch from the build-up phase of recent years to a refinancing market, with lower issuance needs.

Moving on to more liquidity-type products including senior preferred and covered — even though senior preferred is also used for MREL purposes for a good number of banks, especially smaller banks — for senior preferred, the overall picture will be flat to a marginal increase, up to €175bn. What drivers do we see here? On the one hand, the last part of the

TLTROs will effectively be repaid next year, so that could drive up supply a little. On the other hand, we have relatively muted loan growth in banks’ balance sheets. In terms of deposit bases, these are holding up quite well in Europe — there are no massive deposit outflows, no leakage. Therefore, for us, it is more a question of the cost of deposits than deposit outflows, and we don’t think deposit outflows will drive up supply in 2024.

And for covered bonds, we expect around €180bn.

Roper, PGIM: Are you assuming basically flat risk-weighted assets, because loan growth is fairly anaemic?

The deposit piece is interesting, because when you go back to the discussion about central banks, and the propensity of central banks to shrink balance sheets, one of the arguments of QT is sucking liquidity out of the banking system, but I still think there’s a bit of a question mark over the transmission channel and how this will play out.

Benyaya, Crédit Agricole CIB: Happy to hear other views, but in terms of risk-weighted assets, our anticipation is that RWAs will probably increase a little bit, but not that much, and the impact on supply will be marginal. We don’t really see risk-weighted assets moving quickly in Europe. Looking at the latest results, everything appears to be well under control, and we expect that to continue in 2024. We know that there are pockets of risk — commercial real estate is one of them and maybe we’ll come back to that — but the overall picture is broadly stable.

In terms of the deposit base and looking at the results of European banks, again, I think it’s more a question of increasing the cost of deposits rather than seeing deposits leaving the balance sheet of banks. And we are far away from the situation that we see in the US — I’ve never believed that we could see something similar in Europe, because actually there is no nowhere else to go. If you look at life insurance in the major countries, it’s more managing outflows rather than attracting inflows. I don’t feel that retail clients in Europe are willing to go into the money market. Therefore, if you look at the numbers, deposit bases are holding up super-well for European banks.

Leonard, Sona AM: The only country where there has been some deposit reduction is Sweden, where I believe that QT is somehow more linked to deposits.

Collins, Brevan Howard: This is an important point and I’ve been looking into it. What’s important is how the banking system and individual banks are run in terms of loan to deposit ratios. For systems like Sweden and the UK that are at 100%, when the deposit leaves, they need to fund it in a different way. But in Italy, which people always worry about, where it is only around 75%, they don’t. So it’s worth looking, by country and by bank, at how much of the balance sheet is fully-funded versus loan to deposit ratios below 100%.

Leonard, Sona AM: The reason there is this fear is obviously Silicon Valley Bank (SVB) and the speed with which liquidity moves now. They have a slightly different deposit system in the US, but after SVB — and with Credit Suisse, too — the liquidity risk questions from everyone went through the roof. How does LCR work? etc. And we saw lots of bank research analysts doing deposit-watch products, the kind of thing we last saw in the Spanish crisis or the sovereign risk blow-up in 2011. That’s died away a bit, because deposits aren’t moving.

Day, BIHC: We’ve also seen social media amplify volatility and accelerate banking crises — how should this be tackled or addressed?

Delphine Reymondon, EBA: This topic is being considered at the Basel and FSB tables, too. It’s clear that the role of social media and digitalisation has triggered reflections, on whether deposits are as sticky as they were in the past, whether we should amend some rules, in particular from a liquidity perspective, and what it means for contagion risk, which is far higher. In terms of liquidity standards, some might consider it appropriate to amend some outflow rates, for example, or aspects that are not covered as such by the LCR, such as intraday liquidity risk or prepositioning requirements.

But another perspective is also that effective implementation of existing standards and strengthened supervision need to be exercised in full first, before we examine whether some regulatory changes are needed. The Basel Committee issued a report in October where it presented a cascade: you start with the business model of a bank, including the risk management practices and the risk appetite in particular, then you go to strong/effective supervision, and at the end you have robust regulations. When it comes to SVB, undoubtedly the business model, among other things, played a role. As EBA, we have published a lot of guidance for supervisors and for banks via our regular liquidity monitoring reports on the LCR in particular (we started in 2019). Also, the LCR does not stand on its own, there are additional monitoring metrics that exist complementary to the LCR, providing detailed information for example on rollover of funding, concentration by product type or counterpart, mismatches in terms of maturities, you also have information via ILAAP, stress-testing, contingency plans, etc — plenty of tools for supervisors.

The question is, suppose we amend some aspects of the LCR rules, are we certain that this would fill the gap in terms of increased impact of digitalisation or social media? The objective of the LCR is to protect the bank for a 30-day window, so that the bank and the supervisor can take some measures, if the bank is in trouble. And anyhow we would still need to address issues with the usability of the buffer. If the question is, will amending the rules better protect a bank in case of a deposit run? The question remains open for debate.

These are all part of the reflections underway, other aspects are also investigated. In any case, even if Basel were to amend the standards, it would take some time before entering into EU rules. So for the time being supervision is the best tool that we have. Supervisors are already shifting their priorities from capital to liquidity, anyway.

Roper, PGIM: Going back to covered bonds and the ability of the market to absorb what looks like being a very busy year — partly because of TLTROs — at what point does the issuer say, instead of issuing external covereds, I will instead post with one of the central bank’s other facilities for that liquidity?

Hoarau, Crédit Agricole CIB: A tough question and I am not sure I can give you a straightforward answer. Retained covered bond ECB funding is short term funding since TLTROs no longer exist, and covered bonds are term funding, so you’d only go to the ECB to wait for better market conditions rather than arbitrage the cost of retained covered bonds and benchmark covered bonds. The cost of the differential between the two takes into account the differential between the ECB’s MRO and three month Euribor, with the haircut of the retained covered bonds factored in. The calculation implies the comparison between a blended spread level for the retained bonds versus three month Euribor to covered bond wholesale funding versus the same Euribor benchmark.

There’s also a relative value question, namely the cost of issuing covered bonds and putting the collateral at investors’ disposal, versus how much senior preferred funding costs. And this is where views can differ from one bank issuer to another. We also have more and more investors asking us to help them track the covered bond-senior preferred spread differential, something few people did seriously over the past 10 years because covered bonds were trading at silly tight levels. Today, if a strong French bank was to come to the market it might have to pay a minimum of 45bp to ensure that it could safely place a 10 year covered bond, while a 10 year senior preferred from the same bank would be in the very low 100s. This comes back to your comment about the spread differential between senior preferred and senior non-preferred looking very tight. That means senior preferred is attractive for credit investors, and potentially expensive for issuers, but looking at the relative value versus covered bonds, senior bonds are only 60bp back from secured issuance levels on the same part of the curve. And covered bonds looks cheap versus senior preferred. The pricing paradigm across covered, senior preferred, senior non-preferred has been moving around quite a lot over the past 12 months. I don’t think we are yet at the point where we can say, OK, this is the right spread between the two, and I’m quite sure it’s going to take another couple of months, if not a good year before we can say that the relative value scheme across these three funding instruments have settled down for core European names and makes sense.

Leonard, Sona AM: TLTROs could also be cash collateralised, so a lot of banks have been able to reduce their TLTRO amount, by cancelling off the cash they deposit with the ECB. So if they have to pay back €50bn, the impact isn’t that they need €50bn of extra funding; it might be just €20bn.

Reymondon, EBA: We have been having a look at this TLTRO exit from an LCR perspective. We have already published a report in June, and another is imminent. When we published our first report, the conclusion was that it is manageable on average for the EU banking system, but of course, there might still be some individual cases where supervisors would need to have a close look. And it is important to monitor the different movements in the balance sheet of the banks. For example, cash or central bank reserves is going down, so some of HQLA is going down, how is this compensated or not in terms of outflows? There are certain categories of deposits that are exempted from outflow rates, or other deposits with favourable outflow rates, like operational deposits. We are monitoring the different movements. Our liquidity monitoring reports give guidance to banks and supervisors, for example, on how to handle specific aspects of the LCR, where there is some room for judgment on outflow rates to apply to certain categories of deposits, and how to categorise these deposits. We will follow up with supervisors on how this guidance has been applied in practice. We will also see in the coming months if there are changes to the minimum reserve requirements.

As Jenna mentioned, loan to deposit ratios are also playing a key role. All the EU markets structures and competition aspects are different in that regard.

Alloatti, Federated Hermes: When you look at the LCR by currency in December, it makes for very scary reading.

Reymondon, EBA: Indeed, the situation is different by currency compared to euros. We have some detailed analysis in our forthcoming report.

Roper, PGIM: Normally disclosure is a good thing, we have asked for more of it, and banks were very willing to disclose LCRs when they were awash with liquidity. But given how complicated the LCR is, and how reliant it is on various moving parts and assumptions, it worries me slightly how the market is going to react as liquidity is drained from the system and we start seeing LCRs that maybe optically don’t look fantastic. That disclosure could end up being more of a hindrance than a help.

Reymondon, EBA: That is a very good point. What the EU and UK banks have been doing in general is disclosing a lot of information on the LCR, which generally goes beyond the pure regulatory requirements. In the EU, back in time we intentionally took a different approach from the Basel standards, seeking less granular and less frequent LCR disclosures — under Basel it is on a last quarter basis with daily averages, but we said we want last year with monthly averages, precisely to leave some leeway for banks to manage their liquidity needs, especially if they were in trouble, without everything being visible, otherwise they immediately face a stigma. But because there was ample liquidity, and also due to external factors like expectations form credit rating agencies or investors, banks have tended to be willing to disclose a lot. I remember discussions with some banks a year and a half ago, asking what they would do if or when liquidity becomes less ample, because it would be very difficult to go back to less disclosure…

Leonard, Sona AM: And the LCR is just one view of liquidity. I’ve worked in a bank treasury and used to manage liquidity risk.  In reality the loan to deposit ratio is another aspect, then the quality of your deposits and the behavioural aspects of them, etc. But it’s also your ability to raise deposits. Because ultimately liquidity is your ability to meet your obligations in the requisite volumes and at the right price. So pricing is a key part of liquidity risk, but it’s not given enough consideration. Ultimately, liquidity risk has got so many facets that any focus on any one of them at any one time is probably wrong. How do we tackle that when it’s actually the most important thing?

Day, BIHC: Moving away from what in balance sheets is driving supply to the expected issuance itself, how well do you anticipate it being absorbed? And what parts of the capital structure are you likely to prefer?

Skornik, Amundi: We are quite in line the figures that Michael mentioned. Overall, I see the main point as being that net supply will be relatively limited, especially for AT1s and Tier 2. That’s quite important, because post-Credit Suisse, the big question that everyone had was, who’s going to be the buyer of this kind of debt? And whether it would find some support. On day one, a lot of hedge funds came in and bought opportunistically. Since then, demand has been quite good overall. But when you look at specialist funds, the demand is not there. With one exception, I didn’t see anyone get significant inflows this year. So it’s quite important for next year that we don’t get too much net supply if we aren’t seeing more demand. We are expecting some demand. On our side we are seeing a bit of a pipeline, with people starting to return. They’re probably a bit late — we’d been advising them to come back earlier — but especially given that they still enjoy some relative value, with other instruments being more priced to perfection, we think that we’ll see some inflows into the funds. So overall we should be able to absorb any supply, especially if it’s net negative. But it’s quite important, at least in the early part of the year, that net supply that isn’t too positive.

Collins, Brevan Howard: As I indicated earlier, I like Tier 2 and AT1 in decent banks. Investors who are looking at AT1 maybe need to remind themselves that it’s not a good idea buying the AT1 of banks who fund themselves at very high levels in senior and/or are not making any money. But if they’re profitable, have low senior funding costs, that’s probably fine.

Skornik, Amundi: There are counter-arguments to this — the credit profile can also improve. Take BCP, for example: their AT1’s levels were very attractive but in line with only “OK-ish” capital metrics. I believe the investor base was also limited. Now that their figures have significantly improved, the demand for the instrument has certainly grown.

Leonard, Sona AM: The most important thing Jordan mentioned there was net supply: if you looked at net supply across the asset classes, you’d see a much smaller number. And if rates are soft to start with or are heading down, then I think appetite will be fine.

Alloatti, Federated Hermes: But who is absorbing all the €170bn of covered bonds?

Leonard, Sona AM: Actually, the difference in covered bonds is that net supply will be something like €50bn.

Hoarau, Crédit Agricole CIB: The question is how you calculate net supply in covered bonds. If you want to capture the impact on the primary market, you need to factor in the fact that there has been no asset purchase programme in place buying covered bonds since July, and CBPP3 redemptions of some €32bn next year means investors will have to absorb a net €70bn-€80bn of euro benchmarks.

Indeed, while I tend to agree that the net supply element is quite favourable for the junior parts of the capital structure, I would be more concerned when it comes to overall supply and overall market absorption capacity. Factoring in what is coming from the SSA world, including government bonds, and what is coming from the covered bond world, and discounting the fact that we will be without the safety net of an asset purchase programme for the first time since 2009, we will be facing quite a new situation in January 2024. That doesn’t mean that we are not positive or constructive towards next year with regard to market absorption capacity, but this is one element that I would put on the risk list for 2024 — it could be bumpy, and there will very likely be further pricing adjustments. And then we need to look at the swap spread, we need to look at what is happening to German Bunds. So it will not be that easy. At the end of the day, many asset managers may say, I’d rather sit on an IG-rated AT1 or Tier 2 from a prime core bank than anything else. It’s easier to sell a Tier 1 than a covered bond today.

Collins, Brevan Howard: One of the reasons we’re seeing this expensiveness in senior non-preferred is because it’s no longer being incrementally issued, there’s just a refinancing need. It won’t exactly be like Tier 2, but like Tier 2, we may see this vacillation — it gets very expensive and then very cheap because of this scarcity element — and the idea that senior preferred and covered bonds look cheap against it could persist for quite some time.

Day, BIHC: What is the outlook for banks?

Roper, PGIM: Bank fundamentals are really strong. You always have the argument, have you reached peak? But there’s plenty of room for bank fundamentals to deteriorate and still remain incredibly strong.

On the P&L, the biggest, or the most sensitive, line item is going to be pre-provision profit. I say that because you probably saw an outsized reaction in equity with the likes of the UK banks when they were missing NIM, but does that feed into credit spreads? It’s still very difficult to construct a story where as a credit investor you’re worried about some of these P&L trends.

The asset quality piece is one that gets the most attention and CRE is clearly the number one risk factor. But actually when you go through bank by bank — away from some specialised CRE lenders — it’s quite difficult to find any with hugely worrying CRE exposures. You’re normally sucked back into the Nordics, for example, but equally, the asset quality of some of the names in question has historically been pristine — look at Handelsbanken: everybody’s sitting there saying this is impossible, but they’ve done the impossible for 10 years.

Then you come to capital and liquidity. Again, the capital positions of the banks are really strong. And when you think about the amount of shareholder distributions that banks expect to make, especially those doing buybacks, they have plenty of flex to manage the capital base, and they’re still going to be generating organic capital. So that’s a comfortable situation. And then we’ve already discussed the liquidity piece. Whilst deposit flows were a big part of what happened early this year, it’s quite tricky to see a bank having a liquidity shock event where there isn’t a business model challenge. Then you’re again talking about some very small banks with specific issues as opposed to there being an industry-wide issue.

The net-net of all of that is that even though people talk about the macro and the impact of higher rates not yet feeding through into things like CRE, it’s still very difficult to get too concerned about bank fundamentals.

Leonard, Sona AM: The implied cost of equity of European banks is extremely high. If you take the consensus price to book value — let’s say everyone thinks it’s going be 0.5x — and then you look at the implied cost of return on equity they’re expecting — for something like Barclays — the market’s expecting roughly 10% RoE. So you end up with a 20% implied cost of equity, which is extremely high relative to history. Then have a look at US banks — take a US regional bank, which are vulnerable if rates keep going up, they have implied cost of equity of something like 12%. So there really is a big problem with European bank equity. It’s like the investor base has been scarred from years of clean-ups, crazy rules on dividend stopping, and all these kinds of things.

Alloatti, Federated Hermes: And also you have Fannie and Freddie in America — there is no equivalent in Europe.

Leonard, Sona AM: But I think part of the UK bank equity volatility during 3Q23 results was around hedge fund or pod positioning in equity. That’s why the stocks moved c.10% on results day and there were no buyers on the break. It’s just not normal, and feels like these equity markets have kind of broken. So when NatWest missed on NIM in Q3 and its stock price dropped 10% in a few hours, credit didn’t really move, and then the next day the stock dropped again another 4%, which felt like positions being unwound, there were clearly too many people long the stock. So that didn’t create an impact on credit, but it arguably could if we see anything a bit strange in full year results that prompts equity movements — we might see a bit more CRE damage, we might see some change in NIM outlook, particularly because full-year accounts are the most stringently audited. These won’t necessarily reflect the fundamentals from a credit point of view, but I tend to watch cost of equity because it could become a lightening rod into liquidity, for example. But fingers crossed it won’t.

Roper, PGIM: Or unexpected surprises. Take Signa: you think you know which banks have exposure, but were a bank to come out and suggest that they have exposure the market wasn’t expecting, even if it is very manageable within the size of balance sheet and earnings, I think the market would take a particularly tough view of them and question perhaps some of the underwriting lending standards, as opposed to being too worried about what it ultimately means for fundamentals.

Alloatti, Federated Hermes: If we go back 16 years ago, a normal half-decent European bank would have a cost of risk between 50bp and 100bp, and that’s before IFRS9, etc. Today, if a bank gave a cost of risk of 50bp, everyone would say, oh, what’s going on there? That’s a bit scary as it seems out of sync with economic reality.

Roper, PGIM: A lot of banks still have management overlays they can also release to cover some of the credit-specific cost of risk.

One area that’s interesting is, if you have banks that have loans backed by property, typically the provisioning or coverage is much lower, because you have recourse to the collateral, which all makes sense up until you start questioning the CRE valuations. If you have a bank saying it’s got an NPL but the loan to value is 50 so therefore it doesn’t actually need to provide against that, you would take comfort if they could actually work through those NPLs — and the system has done a very good job in bringing down NPLs. But now there’s this question mark, with everybody knowing the CRE market is slightly broken, and it doesn’t take a lot to ask, actually how adequate are the provisions against some of those large ticket items if you simply can’t move the collateral?

But then if it then turns from a specific to a systemic issue, I think all the central banks cut aggressively.

Leonard, Sona AM: It’s interesting, because you mentioned the pre-provision profit line, and with NII, it’s really high now because rates are higher. The worst combo would be cutting rates to zero again, because then all that cushion would disappear, and then there might be an asset quality wave. So in a strange way, if we stay at an ECB rate of roughly 2.5%-3%, that would be ideal — not too hot, not too cold, just right, temperature of porridge.

Alloatti, Federated Hermes: With all due respect to the policymakers, even the ECB is now admitting that negative rates were negative for the banking sector, something they never said for three or four years. Reading between the lines, they didn’t actually say it was a tax on the banks, but they said it had a negative impact on the banks. So in theory, they should say, we’re not going to zero.

Leonard, Sona AM: In fact the best combo is, keep rates around 2.5%, demand comes back, because corporates and individuals realise the world’s not ending and they can invest, and then we accept a world where rates are slightly higher, banks are profitable but can lend because they’ve got lots of capital, and then we have more of an American lifestyle where we make money.

Collins, Brevan Howard: It’s almost like a renormalisation, going back to before all the quantitative easing, where banks can make more money. They have much more capital than they did and maybe they don’t grow as much, which the equity markets don’t like, but they are now moving from one level of profitability to another, perhaps higher level, that then persists.

Leonard, Sona AM: But we haven’t mentioned sovereign risk. As long as governments behave and fiscal rules are followed then that’s all fine, but if we have a sovereign risk blow-up, which is another tail risk for next year, then that all changes.

Day, BIHC: Turning back to the instruments again, there are perennial questions around the structure, behaviour and purpose of AT1s, but this past year has only heightened discussions around the instrument. Delphine, what is your current perspective?

Reymondon, EBA: Yes, it’s interesting how these AT1 discussions keep coming back.

In October the Basel Committee came out with a report on analytical work underway on liquidity, IRRBB, and AT1, with the message that it does not mean that there will be revisions to the framework — which is an important aspect of the communication. The aspects of AT1 that are being debated are, for example, that investors perhaps did not appreciate well the risks of the instruments. I am not certain this was completely the case, because the terms and conditions and risk factors are quite clear and detailed, but maybe it is true of the hierarchy of creditors between the different classes of capital instruments, hence the clarifying statements that several jurisdictions published in March, including us as EBA together with the SRB and ECB. We said in this communication that we support the role of AT1 in the capital structure of EU institutions. At the same time, what is clear is that these are complex instruments, with a low trigger — it was defined before the resolution framework — and it is quasi-impossible to cancel the coupon payment. And there has not been enough testing of the loss absorbency of the instrument in a going concern scenario, as mentioned in the Basel report published end of 2022, so the debate over whether AT1 is a going concern or gone concern instrument is still taking place. AT1s are meant to be going concern, this is the way they are structured in the regulation. But this might not be as relevant a question as it was in the past. What might be more relevant now is whether they can absorb losses and create CET1 or not when needed, when you look at Credit Suisse AT1 instruments have generated a lot of CET1. We have seen also recently with Metro Bank that Tier 2, supposedly a gone concern instrument, can even be touched in a going concern, too. So the division between these two concepts might not be as relevant as in the past. What we need to ensure is that the loss-absorbing parts of the capital structure are there when needed, according to a certain hierarchy, and that the eligibility criteria remain stringent. This is why we have the EBA AT1 monitoring reports that we have been doing from the very beginning, starting in 2014, where we recommend what should and should not be included in the terms and conditions, which clauses can and cannot be used. This stringency in the effective application of the eligibility criteria goes hand in hand with support for the asset class. And we are satisfied that when we publish a report, the recommendations are implemented by the banks, well followed by market participants. Also, AT1 instruments can bring additional funding to the banks and access to a different class of investors. In a nutshell, they are complex, they are not perfect, but they have some merits. But we’ll see what happens at the Basel table and if some regulatory changes are decided, and if these changes could come without rethinking all the buffers framework, which is certainly highly complex.

Alloatti, Federated Hermes: This debate has not gone away because it is important to us as investors. You should make the instrument a bit more fixed income friendly. I think there is a bit of a misconception around the extent to which AT1 is bought by equity investors — I think it’s only marginally so, 5%-10%, at most.

I have talked to the ECB, to the PRA, and I don’t understand why there is no dividend stopper. You said you respect the capital hierarchy, but if you say so, then in my view you should fight a battle in order to reopen CRD and introduce this dividend stopper. What you said about no one skipping the coupon is not quite right, it is a misconception, because the coupon is optional. I’m not sure why anyone would, but in theory they can, and it’s very dangerous because we know that tomorrow a bank could decide not to pay the coupon, so why not introduce this dividend stopper?

And then if you want to go further, make the coupon cumulative. I know it’s very difficult, but while the instrument is not perfect, this is not reason enough to stop trying to make it more perfect.

Reymondon, EBA: We also heard these arguments in the past. It is not advisable to touch the AT1 class, especially at the moment, and especially if it is to water down eligibility criteria, so as to maintain credibility of the instruments. Dividend stoppers would probably not have made a difference in the Credit Suisse case. Bear in mind that there is one case where the hierarchy would still be inverted, namely if you hit the regulatory trigger. You might say, it’s very unlikely, because the trigger is too low, but in this case, the hierarchy would be inverted. All these dividend pushers, stoppers, reverse stoppers etc and things we saw in the past were similar types of mechanism that, in a way, created more complexity, and we wanted to introduce more simplicity. Already at the time of CRR1 we received comments that no one would buy the instrument with all the aspects that we designed — like how it would take ages to get a write-up on the instruments for the ones with temporary write down — but in the end, there are still quite a lot of buyers of the instruments.

Benyaya, Crédit Agricole CIB: I agree with Delphine in the sense that today I feel that we need stability in terms of AT1 criteria. The Credit Suisse write-off was a shock to the market, let’s not forget that. Now the market has restarted, I feel we are seeing investors coming back to the asset class, and we need stability. And to me, all the discussions around dividends stoppers, pushers, coupons cumulative or not, I don’t think it will massively change the behaviour of the AT1 instrument.

Skornik, Amundi: It could alleviate some pressure sometimes. During Covid there were a lot of questions was around this — and in practical terms, we actually had dividend stoppers. The question is, so this is a perpetual bond where they can stop the coupon and still pay a dividend forever? Even if a CFO would not do this, why not give investors some comfort that it is definitely not going to happen.

Benyaya, Crédit Agricole CIB: Remember that many European banks declared that they would observe the hierarchy between dividends and AT1 coupon payments.

Skornik, Amundi: But you need to have this confirmation.

Benyaya, Crédit Agricole CIB: Yes, exactly. So it’s not in the documentation; it’s like a management policy.

Alloatti, Federated Hermes: So why not put it into the documentation and the law? Because personally I think the AT1 market is one accident away from being a museum piece. There is demand today, but if something were to happen in the next six months, I don’t think the market would reopen.

Leonard, Sona AM: It depends on the price. That’s my view, always. I was buying right after CS.

Skornik, Amundi: The demand is not the same demand as in the past. The specialist funds, they haven’t seen demand following CS.

Leonard, Sona AM: UBS did quite an interesting thing in the documentation of their recent AT1: their new prospectus was a sea change in explicitly explaining why this instrument can be bailed in. And I quite enjoyed the read. It basically said: you know everything that happened to CS AT1, well we are now making explicit how this can go wrong for you as a holder — caveat emptor. That was the right approach to explaining it — and selling bonds a bit cheap helped, of course.

Collins, Brevan Howard: As nice as it is for a credit investor to have dividend stoppers and whatnot, you need to be able to raise equity in a distressed situation, and so you need to be able to entice equity in any way possible. People just need to know that if you buy capital, make sure your bank is profitable and funds itself cheaply, and if you’re not comfortable with that, then you should be in senior.

Leonard, Sona AM: I’m a bit more laissez-faire. l really think banks should be allowed to fail more often, because when banks fail — where it isn’t the fault of the regulator — then the other management teams realise there is a cost to managing poorly. A lot of banks have gotten away with things in the last 10 years where they should have been bailed in or gotten rid of, which would have made behaviour improve, rather than giving them more rules. And management teams should be punished by losing their jobs or more when that happens. Saving everything all the time is not the right approach.

Alloatti, Federated Hermes: That works in theory, but in practice it’s a political decision.

Day, BIHC: What do the latest issuer and regulatory actions imply for capital instruments call management?

Reymondon, EBA: There were previously more liability management exercises in the UK and far fewer in the EU, and we were regularly asked why, whether the EU regulator was stricter on some of the rules allowing for this. But the situation has changed somewhat and the trend that we see now of having more refinancing before five years is welcome. We have always monitored how supervisors have been exercising the notion of “exceptional circumstances” where you can redeem or repurchase the instrument before five years, and the view among supervisors was that a lower cost would not be considered a sufficient factor to be deemed an exceptional circumstance. In all cases, this assessment needs to remain a case by case basis, which is why the EBA did not want to further define what exceptional circumstances should be. There are plenty of different elements that need to be considered: the specific situation of the bank, its size as an issuer, the frequency of its issuances, the impact on other classes of instruments, access to the investor base etc. What we have tried to do from an EBA perspective is, firstly, to provide more flexibility where possible. We did this for example in pushing back in time the point of the deduction when the bank has received the prior permission from the competent authority to call or redeem an instrument. But very importantly, we continue to carefully monitor all these transactions. We ask supervisors to present to us under which conditions they have allowed some of these transactions and we monitor the treatments applied by the banks and communicated to the markets. We still need to pin things down a bit and to ensure that there is convergence in practices among supervisors.

It’s appreciated that there are more LMEs. They are particularly warranted in the current market conditions, because after all, we may have more stable conditions today, but uncertainty is still very high and we do not know what might happen next year. If banks have windows of opportunity, it’s good that supervisors can find ways to warrant the refinancing — as long as it’s not like one year after the issuance, obviously. But we need to and we will continue to issue Q&As or additional guidance to market participants and supervisors where necessary, again, to ensure convergence and consistency.

Roper, PGIM: Are you’re having similar discussions as well on Tier 2?

Reymondon, EBA: It’s for all instruments — it’s just that AT1 is the one that is more often in focus. We would need probably to work a bit more closely with resolution authorities going forward, because the permission regime for them is more recent for them, compared to supervisors, who are now quite used to our guidance.

Day, BIHC: Jordan, did you have any thoughts on call management?

Skornik, Amundi: I think we have become used to this call, non-call issue, at least on our side. And we have benefited quite a lot from it, having been able to do some relative value trades around it, so I’m happy for the opacity to remain. And it’s funny you mention Tier 2, because while we have long done these relative value trades between AT1 based on resets, we never previously thought about doing the same for Tier 2, but are now doing so — maybe a bit less today, but last year there were plenty of opportunities where people were buying something that to maturity was as good as a bullet Tier 2 but with the optionality for you.

Roper, PGIM: I was more thinking about liability management on Tier 2s, and into a higher cost instrument. How far ahead of call would a regulator or a supervisor be happy to allow a bank that maybe doesn’t have as regular access to capital markets to be able to do that type of transaction?

Reymondon, EBA: I mentioned that it is probably too stretched if after only around one year you already want to refinance. We don’t have criteria prohibiting this, and it’s more for supervisors to assess, but it should not be so far in advance compared to the first call date.

Leonard, Sona AM: Some banks’ CET1 ratios and now so high that, Tier 2 hardly matters as a bucket. I guess it’s cost effective, but at some point shouldn’t they just be allowed to call based on where their CET1 last printed? And their future profitability? To me, going to the school teacher every time you hand in a bit of work just seems a bit much; shouldn’t you let them be grown-ups and say, you manage this?

Reymondon, EBA: There are capital planning and funding aspects to it, too. You might also want different types of instruments to match your funding structure. So I’m not sure banks would always be willing to call Tier 2 instruments in advance even if they have high level of capital in other classes/layers.

Benyaya, Crédit Agricole CIB: And sometimes they are also needed for rating agency purposes. Regulation is one driver of capital, but the ratings agencies are another, and it’s true also for Tier 2.

Day, BIHC: To what extent is CMDI and the potential impact on depositor preference and senior preferred versus senior non-preferred something to watch?

Benyaya, Crédit Agricole CIB: At this stage CMDI is still a proposal from the European Commission and the legislative process is still going on. It will probably happen, but there is still a lot of work to be done before it can become a law that can be implemented.

The proposal today is indeed to make all deposits super-senior in the capital structure — so even going beyond what we have seen in Italy and Portugal, for example. In that situation, senior preferred will be in a different position, because there will be only a single stack, with only senior preferred, and below that senior non-preferred. We know very clearly that there will be a rating impact, because Moody’s communicated that there will be a pretty much automatic one notch downgrade on the senior preferred of the vast majority of banks, losing one notch on the senior preferred.

The current proposal would keep senior preferred pari passu with derivatives, so senior preferred will not qualify as subordinated MREL. Therefore, senior preferred and senior non-preferred will continue to exist with different positions in the liability structure and playing specific roles, senior preferred for total MREL, senior non-preferred for subordinated MREL.

Such an implementation of depositor preference in Europe would, of course, have implications for the senior preferred versus senior non-preferred relative value discussion.

Roper, PGIM: I can see the argument that’s pushed, that senior preferred and non-preferred spreads will have to tighten, because technically you are now ranking junior to depositors. My issue is that to me, senior preferred is a funding tool, is for liquidity, and senior non-preferred was designed as an effectively gone concern instrument, and it’s when you start narrowing the gap between the two that the problem starts: I still think it would be very difficult in a bail-in style scenario to impose losses through senior preferred, partly because of the complications around ranking pari with derivatives, and partly because in certain geographies, especially Italy, there are still a lot of retail bondholders in senior preferred, so you then have the political angle. It’s very valuable for the European banking system to have a funding tool like senior preferred, and if you start using it as a way of recapitalising banks, it then becomes more of a non-preferred style instrument. So I can see the argument as to why you would trade them tighter, but I personally still think that senior preferred should trade decently inside where non-preferred trades today, even with the depositor preference noise in the background. Take a very small bank that’s using senior preferred to meet its MREL: there are a lot of resolution tools available, so you don’t necessarily need to have bail-in — you could have a sale, you could probably liquidate it. It would be very difficult for someone to want to impose losses through senior preferred just because of the impact it would have on a lot of smaller banks and their ability to raise senior funding.

Alloatti, Federated Hermes: But conceptually, it’s possible.

Roper, PGIM: Conceptually, it’s possible. I just think that you’d lock a lot of small banks out of the senior preferred market, and do people want to do that?

At the moment, banks are at times a little disingenuous when they say, look, its senior preferred, but bail-in-able. You get tier two, tier three banks in Spain or Italy using senior preferred where actually there’s not a lot of securities junior to the senior preferred — you go straight to Tier 2 — and the question is, if you have an event at that bank, what on earth does a regulator do?

I would have much preferred MREL to have to be met with subordinated MREL. It’s much cleaner. And then senior preferred becomes your funding tool. Look at the Canadians now: they don’t have the two tiers of senior, just one that’s effectively for bail-in, and after that you have covered, so when the covered bond market isn’t functioning they have a real issue in terms of having an attractively priced instrument to fund.

I like how issuers such as Crelan say that they are going to meet their MREL with subordinated, it’s nice and clean. The way the Dutch and UK banks do it is really clean — maybe it just comes down to having the HoldCo structure.

Skornik, Amundi: At the same time, the current set-up maybe gives the smaller issuers a bit of time to build market confidence to issue senior non-preferred at some point.

Collins, Brevan Howard: Yeah, but things happens when we don’t expect them to, right?

Roper, PGIM: And then you have to transition your capital structure from one with senior preferred by refinancing with non-preferred, so it will actually take a lot of time before you’ve got to the end state where all MREL is met with a subordinated instrument.

Leonard, Sona AM: The ratings point was made earlier, and I believe RBI issued a senior non-preferred to protect their senior rating earlier in the year, which was their first attempt to put a wafer thin layer there. So maybe rating agencies will be part of that discipline.

Roper, PGIM: And if you had depositor preference in Germany, for example, why on earth should it make any difference to Deutsche senior preferred? They’ve got such a big stack of non-preferred, the size of the loss you’d have to generate to get close to the senior preferred is bonkers. So it’s very case by case dependent. For banks that are using preferred and have no non-preferred, you should be trading the preferred as a non-preferred today, and then for banks that have very, very large non-preferred stacks — your large French banks, your Deutsches of the world — I don’t see why depositor preference makes any difference at all aside from maybe having a mechanical rating impact.

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Photo: Commissioners Mairead McGuinness and Valdis Dombrovskis, and spokesperson Sonya Gospodinova announcing the proposals; Credit: Valentine Zeler/EC

European Commission proposals to position all depositors above senior unsecured debt in banks’ liability hierarchies could trigger Moody’s downgrades of many banks’ bonds and prompt shifts in funding strategies, although the initiative is already encountering resistance.

Released on 18 April, the crisis management and deposit insurance (CMDI) framework proposals have been under discussion for several years, but found renewed resonance in the wake of the collapse of Silicon Valley Bank (SVB) and emergency rescue of Credit Suisse in March.

As well as aiming to increase confidence in the banking sector and reduce the chances of a bank run, the measures seek to reduce the likelihood of taxpayer money being used to support banks outside the EU resolution framework, and make it easier and more likely for deposit guarantee schemes and resolution funds to be used instead and as envisaged according to previous initiatives such as the BRRD.

“Today we are taking another step forward to ensure all failing banks can be handled more effectively and coherently should the need arise,” said Valdis Dombrovskis, Commission executive vice president for an Economy that Works for People. “Our principles remain the same: to preserve financial stability, protect taxpayers’ money and improve depositor confidence.

“These proposals will also help to finalise the Banking Union: a cornerstone of a successful Economic and Monetary Union.”

The core part of the CMDI package consists of three legislative proposals making targeted amendments to the BRRD (Bank Recovery & Resolution Directive), the Single Resolution Mechanism Regulation (SRMR), and the Deposit Guarantee Schemes Directive (DGSD).

While the ambition of expanding resolution to encompass more small and medium-sized banks — as opposed to liquidation under national insolvency proceedings — had been expected, the proposed introduction of general depositor preference was less anticipated. A goal of the latter, as well as the proposed pari passu ranking of all deposits, is to help make possible the financing of resolution measures by funds in deposit guarantee schemes (DGS).

Instead of enjoying a super-senior ranking, insured deposits and hence DGSs will rank pari passu with non-insured retail deposits and uninsured institutional depositors, increasing their ability to absorb losses, in parallel with an increase in the cost of compensating depositors, and potentially contributing to the 8% TLOF criteria required to access resolution funds.

“The overall result is that DGS would be able to absorb losses at an earlier stage, giving governments a greater incentive to deploy resolution tools rather than wait for the bank to be liquidated,” noted Moody’s. “DGS could if necessary provide the resources needed to protect the depositors of smaller banks in resolution after their bondholders had been bailed in. The relevant national resolution fund (or SRF (Single Resolution Fund) in the case of the Single Resolution Mechanism) would compensate the DGS if the cost of its intervention in resolution turned out to exceed the cost of a liquidation.”

Current and proposed EU bank liability hierarchy

Source: European Commission, Moody’s

From ‘de facto’ to ‘de jure’

As alluded to by the rating agency, under the Commission’s proposals, all depositors across the EU would rank higher than senior unsecured bondholders. While this is in line with the prevailing hierarchy in eight EU member states (including Italy and Portugal, for example), it will represent a significant change in the majority, including jurisdictions such as France, Germany and Spain.

“The EC’s proposal for full depositor preference is credit negative for senior unsecured debtholders in these jurisdictions, since their claims would no longer benefit from loss-sharing with depositors,” said Moody’s.

“Conversely, there would be an additional benefit for uninsured institutional deposits. These would now not only hold equal rank with all other deposits — as in the case of the seven current full depositor preference countries — but they would also benefit from greater volumes of subordinated liabilities, now including senior unsecured debt, to absorb the burden of losses before depositors.”

While Fitch and S&P do not anticipate the proposed general depositor preference to result in rating actions, Moody’s has highlighted the potentially widespread impact that would ensue under its methodology for banks in jurisdictions facing change.

Although Moody’s in its credit opinions of banks places most weight on the current legal liability EU pari passu waterfall — dubbed the “de jure” waterfall — it also bears in mind the discretion resolution authorities have when applying resolution measures. It captures this possibility that depositors may ultimately be ranked above senior unsecured bondholders — the “de facto” waterfall — by assigning this scenario a 25% weighting versus 75% for the de jure scenario.

“The de jure scenario of tomorrow is more or less the de facto scenario that we already run and which is reflected in our credit opinions,” explains Alain Laurin, associate managing director, EMEA banking, at Moody’s.

Under the rating agency’s Advanced LGF analysis, whereby notching for different liability classes is based on their assessed loss severity, divergence between deposits and senior unsecured ratings could occur more often if the CMDI proposals are implemented in their current form.

In response to strong interest from investors, Moody’s at the end of May published an analysis of the potential impact of the proposals on 119 banks that have relevant public information available. This found that deposit ratings would enjoy higher notching uplift for 47, and that senior unsecured debt notching would be lower for 89. The rating agency’s data shows that at least a dozen senior unsecured ratings could fall out of both the double-A and single-A categories, while a couple could be downgraded to junk, all other things being equal — not a given at this early stage.

Moody’s distribution of current senior unsecured or issuer ratings in EEA countries by rating and difference under the full depositor preference (“de facto”) scenario

Scorecard data is as of 26/5/23. Excluded are those ratings based on private LGF data and where current assigned LGF notching differs from the weighted outcome of the de jure and de facto scenarios. Rating categories with no entries omitted. Source: Moody’s

A Crédit Agricole CIB analysis painted a similar picture, finding that around 90% of larger banks’ senior preferred ratings are at risk of being downgraded by one notch, while 50% of deposit ratings could see a one-notch upgrade.

“Clearly there could be some impact on funding costs from a rating downgrade,” says Alpesh Varsani executive director, DCM financial institutions, at Crédit Agricole CIB. “It’s difficult to put a number on that, but where key rating thresholds are crossed, we would expect a more material impact on investability and pricing, as well as where they sit in the various indices.”

Such a scenario would also see the notching and hence pricing differential between senior preferred and senior non-preferred debt narrowing. This could mean that, although larger banks’ funding and capital requirements will not change as a result of the proposals, they explore ways of tamping down their costs.

“It’s very early days,” says Varsani, “but if banks just need funding and don’t need to issue for MREL, they could potentially in future do this not via senior unsecured debt but via a new form of instrument, a structured deposit, that could benefit from being higher up in the hierarchy and so cheaper than where senior preferred is today.”

Changes to spur MREL issuance

The CMDI proposals could meanwhile see more small and medium-sized banks facing MREL requirements, a pre-condition of accessing resolution funds, given the Commission’s goal of resolution being preferred to liquidation or other solutions outside the EU resolution framework.

For instance, Moody’s notes that a key objective of the package is to allow DGS to play a role in facilitating “purchase and assumption”, whereby the assets and liabilities of a failed bank are acquired by a functioning peer, for mid-sized European lenders.

“Their contribution would be capped at their exposure in an insolvency, and would not exceed any shortfall in the value of assets transferred to match the deposits and more senior liabilities assumed by the acquirer,” said the rating agency. “DGS funding would also be conditional on the failed bank holding proportionate volume of MREL to facilitate a transfer strategy.

“This would likely result in a much larger number of EU banks being required to hold an RCA (recapitalisation amount) as part of their overall MREL requirement.”

A host of smaller and medium-sized banks could therefore enter the public senior debt market in the future, says Varsani (pictured).

However, Laurin sees two categories of banks: those subject to a positive recapitalisation amount; and those that are only required to comply with the loss absorption amount (LAA) (the RCA being set at zero).

Furthermore, he notes the oft-cited mantra of Single Resolution Board (SRB) officials, that when it comes to resolution in line with the BRRD, “it is for the few, not the many”. According to Moody’s, while the SRB is the resolution authority to 120 of the largest European lenders, the size of current RCA requirements for the remaining 2,085 euro-area institutions suggests just 64 would be resolved.

“The problem for these retail banks is that they collect deposits, do not need funding, and they cannot easily access the capital markets,” adds Laurin. “So issuing to meet MREL requirements will not be straightforward.

“So perhaps MREL requirements will be imposed for only a very few of the mainly larger medium-sized banks.”

MREL requirements in Europe (% of Total Risk Exposure Amount (TREA))

Source: Company reports, Moody’s

ECB supportive, but battles ahead

A lengthy and difficult legislative process is anticipated, until at least 2025, and some question whether the CMDI proposals will ultimately be implemented. This is partly because they are seen as another step on the road to the envisaged European Deposit Insurance Scheme (EDIS), which has been on the backburner for some time due to political hurdles that the latest initiative only underline.

“The larger banks in the larger countries such as France and Germany already represent the biggest contributors to the SRF as well as their national DGS,” says Varsani, “and having an expanded scope could mean they are expected to contribute more in order to support smaller banks — and the objections are only going to be stronger if it’s now on a Europe-wide basis.”

A consultation is underway until at least 29 August (after having been extended to allow for EU translations), but the first feedback has already been submitted and published on the Commission website, and the German Savings Banks Association (DSGV) has objected to the proposals. Market participants had anticipated resistance from Germany — partly due to how the measures could clash with national institutional protection schemes (IPSs) — and the association objects to several key elements of the proposals.

The DSGV echoes Laurin’s comments on the difficulty of smaller banks issuing debt to meet MREL requirements, as well as DGS contributions in the context of resolution.

“The proposed approach of making resolution the standard for crisis management in the banking sector,” it says, “is foreseeably more bureaucratic and financially burdensome, especially in the case of small and medium-sized institutions.”

As well as the two responses included on the Commission consultation website as of Friday (14 July), the European Central Bank on 5 July published an opinion on the proposals, after the SRB and ECB had initially published a joint statement welcoming them on the day they were released.

The central bank welcomed the proposed expansion of resolution for smaller and medium-sized credit institutions, adding that it is imperative that this be accompanied by adequate resolution funding.

“Without improved access to funding, expanding the scope of resolution risks being impossible to implement in practice,” it said. “The ECB therefore fully supports that, building on the principle that losses in a credit institution failure should be borne first and foremost by shareholders and creditors, the proposed legislative package also provides for a stronger role for deposit guarantee schemes in resolution, subject to certain safeguards.

“It is important that such role is facilitated by a harmonised least-cost test and a single-tier depositor preference.”

Among other elements of its feedback, the ECB proposes to give IPSs preferential treatment, and also seeks to ensure that there are adequate safeguards for accessing resolution financing arrangements in cases of systemic crises.

Please click here to download the roundtable in pdf format.

Vincent Hoarau, Crédit Agricole CIB: Could you summarise the main themes in the asset class in terms of issuance dynamics and spread drivers since the beginning of the year?

Florian Eichert, Crédit Agricole CIB: We basically moved from not having a market, to having a market again on both sides, secondary liquidity as well as primary supply. We’ve come from years where the ECB was distorting supply — with TLTROs limiting funding needs — and on top of that squeezing the residual liquidity out of the market through large-scale asset purchases. So the market was shrinking in terms of free float and losing traction with investors, who perhaps only put in a few new issue orders and then forgot about the secondary market. We have now moved to a situation where banks are no longer underfunding, but overcompensating, as they now need to repay the TLTROs. Hence, supply is up and we are experiencing record volumes. That has improved liquidity and brought investors back. Higher yields have played their part, of course, but the sheer level of activity in this market is drawing old, established players back in, and also drawing in newcomers who hadn’t been looking at the covered bond space before QE. Supply is high, it’s broad, and fortunately it’s also broader on the investor side.

Across the entire year investors have had a very positive stance vis-à-vis covered bonds. Asset managers have been de-risking and moving money into this market, and bank treasuries have been investing the excess liquidity they didn’t invest last year. So overall it has been a very strong market.

But more recently, in the past one to three weeks, it’s been heavier going in terms of supply but also how these bonds have been absorbed. Some trades barely managed to get across the finish line and, unfortunately, the negative sentiment from these trades hasn’t kept further issuers from approaching the market. We had a large EIB seven year yesterday with a €35bn order book and at the same time some of the covered bonds really struggled.

However, I believe this is more of a shorter term theme and a few weeks with more limited supply will go a long way towards alleviating some of this short term pressure.

Hoarau, Crédit Agricole CIB: You say the dynamic has changed in the past couple of weeks. At the beginning of May, Christine Lagarde announced the end of the reinvestment of APP redemptions. We all know CBPP3 has long played a tremendous role in supporting the asset class. Hence, it’s the end of an era from July 2023. Is it going to have a major impact on covered bonds overall? And what could be the impact on the OBG segment in particular?

Eichert, Crédit Agricole CIB: There has already been a big impact, because Eurosystem primary orders have come down from 50% at the peak to zero. On the back of this, we’ve had a massive widening and spread decompression, across jurisdictions and also within jurisdictions. Hence, to a large extent I would say that the QT effect is already priced in.

There’s just one thing that I’m nervous about when it comes to secondary flows stopping in July: if we were also to have more issuance than expected in the second half of the year, the absence of CBPP3 flows could lead to the market gapping one leg wider. At some point, PEPP will be able to mitigate some of this, but I think they will not start firing straight away; they will want to wait and see some pain in the market before that gets deployed. However, if the market consensus turns out to be correct and we are in for a quieter H2, then we should be able to deal with no more secondary purchases fairly easily.

Hoarau, Crédit Agricole CIB: Because if we crunch the numbers, in March alone around €5bn of covered bonds on the ECB balance sheet redeemed, if I’m not mistaken.

Eichert, Crédit Agricole CIB: Yes. And — in what, to me, is a good sign for Italy — the ECB underinvested these March redemptions. Hence, if Italian issuers start issuing in the second half of June, there’s effectively still two weeks left for the ECB to support the reopening of the OBG market early on. Beyond that, PEPP is not going to be a big player in the covered bond space, but I do get the sense that the ECB almost feels sorry for Italian issuers, as the Bank of Italy kept them out of the market almost up until the point that APP is no longer buying covered bonds. I don’t want to say there’s a mini-pocket in the PEPP that is sort of reserved for OBG purchases, but in any case, in the second half of June you may have a bit of a mini-revival of CBPP3 purchases before it then comes to an end at the beginning of July.

Hoarau, Crédit Agricole CIB: But my point was just to say that this type of support is now disappearing completely.

Eichert, Crédit Agricole CIB: Yes. But again, it all depends on supply and whether banks are two-thirds done with their funding or not. After all, the backdrop for covered bonds is still supportive: spreads are still wide versus govvies and versus SSAs, yields are high. However, if supply stays high and the ECB is gone, trading books are going to be less aggressive in bidding for paper and you will clearly feel an impact on the market.

Hoarau, Crédit Agricole CIB: Turning to the issuers, have 2022 and 2023 funding plans been significantly impacted by the fact that you were unable to issue OBGs? How did you navigate through funding needs since the beginning of last year, in the context of TLTROs coming to an end?

Francesco Villa, Banco BPM: In our case, we were very active in the primary market. We have been more focused on the senior unsecured space and subordinated debt in order to fulfil our regulatory requirements. We did a green covered bond in March 2022, which was a very good transaction, but we have not been impacted by the Bank of Italy delay because we have a lot of liquidity. Our funding is still supported by TLTROs. We have a lot of long term repo trades using retained covered bonds — this is a very important tool to support our indicators. So we have only really been impacted in terms of time to market, because it’s true that last year we had envisaged issuing another covered bond but we were not able to. So this year, for sure, we have been forced to change our plan a little bit, but we want to tap the market with a covered bond before the summer break, also because we have another transaction to do by year-end. At the end of the day, we have not been negatively impacted by this delay.

Stefano Sibari, Credem: We have also been very active in the market in 2022. We issued a senior preferred, a subordinated Tier 2 and a covered bond. Historically, we have always been present on the market with at least one issuance of benchmark covered bonds per year. Hence, when we saw that there was some delay with the Italian regulation last year, we decided to anticipate our issuances and we issued a €500m covered bond in May. After the hard deadline of 8 July, we closely monitored the Bank of Italy’s progress. In developing the 2023 funding plan, our strong liquidity position and indicators allow us to wait and see how the market and the Italian regulation would evolve. Covered bonds remain a strategic instrument for us, and we will closely monitor the market to find an attractive window in the near future.

Stefano Marlat, Crédit Agricole Italia: On the market, we only issue covered bonds — nothing else. This means that in 2022 we did what we had in mind at the beginning of the year. Also, we use the market not so much for funding in itself, but to manage the funding mix, to differentiate the investor base and to reach long and extra-long durations — which is evident from our past issuance.

At the beginning of this year, we could not do what was planned for 2023. However, at that time, the market was very crowded and focused on really short tenors. So although we had to wait, I don’t even know if we would have approached the market had we been able to, given the prevalence of these short tenors which were favoured by investors.

Hoarau, Crédit Agricole CIB: Coming back to the change in the OBG framework so that everyone understands why we are where we are today and why Italian issuers are still not technically able to issue OBGs — perhaps can you guide us through what the main obstacles were and why we had this delay?

Villa, Banco BPM: It was more of a fine-tuning process overall, because the Italian OBG framework was pretty much in line with the new requirements set by the covered bond directive. Rules around internal controls, but also in terms of the general structure, new requirements in terms of liquidity buffers and in terms of overcollateralisation were all more or less in place in our covered bond programme already. So, it has just been a matter of updating the programme and being aligned with the new regulation.

The biggest concern was regarding the transitional regime Bank of Italy put in place within the new regulation. During the consultation period, we had a very constructive discussion with Bank of Italy, though, and the notice period between communicating to Bank of Italy our intention to issue a new covered bond under an already-established programme and the actual first issuance was reduced from 60 days to 30 days. This 30 day period is manageable. It’s a period where banks have to complete all the internal approvals, change the internal procedures in order to be ready to issue in line with the new framework. So, implementation was a real challenge for banks, but everything has been resolved through very constructive discussions with the regulator.

Hoarau, Crédit Agricole CIB: Moving to the critical topic of higher interest rates, what has been the greatest challenge for each Italian issuer in this respect since the beginning of last year?

Tom Lucassen, Banco BPM: At current levels, for a commercial bank with a strong retail footprint like us, it’s less a challenge and more a great opportunity. It is in light of the interest rate hikes that we have continued to raise upward our guidance in terms of profitability. Profitability guidance has also been raised on the back of other factors, including the path towards normalisation of the cost of credit risks and operating costs being under control. However, net interest income (NII) is the key driver. In November 2022, we had guided towards a total NII of more than €2.5bn to be reached in 2023 with an underlying interest rate level of about 2%. In February 2023, we moved our expectation up to more than €2.7bn, with an underlying interest rate level of about 2.5%, and just recently, in conjunction with the presentation of our Q1 2023 results, we revised our guidance up further to more than €3bn, with an underlying interest rate level of 3.3% in terms of average Euribor. This has been the key driver behind our upward revision of bottom-line profitability, with our net income expectation for 2023 up from €740m originally embedded in the Strategic Plan that we approved in November 2021 to about €1.1bn. At the same time, for 2024, our net income target of €1.05bn in our original Strategic Plan has been revised upward to a new guidance just below €1.4bn. As a bank with a strong retail focus, some 82% of our funding is represented by customer deposits with a relatively low cost of funding. In fact, we have seen a significant degree of stickiness in the cost of these deposits, which has moved up from 5bp in Q3 to 24bp in Q4, and up to 46bp in Q1 of this year. With an observed deposit beta of about 33%, we expect to further shore up our underlying profitability, and the NII guidance of more than €3bn that we have recently provided may turn out to be prudent, in particular in case of a scenario of higher interest rates, from which we stand to benefit given our positive NII sensitivity. We will update and approve our Strategic Plan in the second half of this year, also considering that the general economic assumptions have changed so radically.

There is, of course, the question whether the rise in interest rates has negative repercussions on our asset quality. However, if we look at the default rate, we stood at an annualised level of 88bp in Q1 2023, which compares with 94bp seen in the full year 2022, so that, at this stage, we are not seeing a deterioration. Let me add that our group comes from a very high level of NPEs and over the past years we have been focusing sharply and successfully on the reduction of our NPE exposures and on the de-risking and improvement of our asset quality profile. Actually, we are two years ahead in terms of achieving our gross NPE ratio target: for year-end 2024, we had pencilled in a 4.8% gross and 2.5% net NPE ratio target, while today we are already down at 4.2% and 2.1%, respectively.

Sibari, Credem: The current dynamics of interest rates are leading to higher profitability, mainly driven by the increase in NII started in the second half of 2022. There are more opportunities than challenges in the current scenario. Our business model is highly diversified, therefore, on top of a resilient fee component, we found a renewable profitability coming from new NII levels while maintaining outstanding levels of asset quality. Furthermore, we have a more than comfortable liquidity position, which translates into less competition on the deposit side, avoiding, for the time being, rapid increases of average interest rates on our clientele’s deposits. Indeed, the cost of funding from our customers increased at a lower pace with respect to that on the loan side, favouring the widening of customer spread and, therefore, supporting revenue growth. Interest rate rises might lead to potential contraction in loan demand and to deterioration in asset quality. However, we are not seeing any material signs of contraction in loan demand nor any signs of deterioration in asset quality so far, with a year-on-year growth in loans to customers that stood at +3.2% as of 1Q23, while registering 5bp of annualised cost of risk as of 1Q23. On the securities portfolio side, interest rate risk is hedged, so there’s limited/negligible impact from interest rate rises.

Marlat, Crédit Agricole Italia: In terms of the impact of rising interest rates on our bond portfolio, there is really no impact, as we manage our portfolio in terms of spreads, not in terms of rates. And in terms of lending and what the others have said, you can imagine that we are also taking advantage of that. Things are much more interesting on the funding side. As I said, we have limited market funding needs as we are cash-rich. In terms of our client base, with extremely low or even negative rates, a lot of liquidity went into current accounts. However, the recent rates moves have led to clients asking for higher interest rates again. So what we try to do is to offer time deposits or within our retail network to start issuing senior bonds for only our clients. However, for the time being it’s still very limited and used much more to attract new clients. In any case, it’s difficult to find tenors longer than three to five years with private customers via term deposits or senior notes.

Hoarau, Crédit Agricole CIB: Nicola, what are the main rating drivers for Italian covered bonds at Moody’s? How is country risk factored in? And has covered bond directive implementation and the changes to the Italian OBG framework led to an improvement in TPIs, and hence the rating uplift above the issuer?

Nicola Selvaggi, Moody’s: Italian mortgage covered bonds are rated Aa3, the country ceiling for Italy. Country ceilings indicate the highest rating level that would generally be assigned to the financially strongest debt from issuers domiciled in a country. This ceiling effectively constrains the highest achievable rating for Italian covered bonds at their current level. The main driver remains the issuer credit quality, which is the starting point for our analysis. The quality of the cover pool underlying the covered bonds is high and therefore less of a driver in our rating analysis. These aspects remained unchanged with the new law.

Perhaps it is worth taking a step back to look at our methodology. This is based on a two-step approach. The first is numerical, so the calculation of the expected loss, which drives the OC requirement for a given rating. And then, a more qualitative step, the timely payment indicator (TPI) framework, which assesses the likelihood that the issuer will make payments in the aftermath of an issuer insolvency and limits the maximum achievable rating of a covered bond. Now, considering that the country ceiling is a further cap to this, it means that covered bond ratings have a certain leeway or buffer against issuer rating downgrades. In general, the leeway is between one and two notches in Italy. For the sake of completeness, movements in the sovereign rating will likely have a direct impact on Italian covered bond ratings.

With regards to the new legislation, its impact is positive. However, even before the recent changes, Italian covered bonds benefited from strong credit standards as the contractual provisions present in OBG programmes were stricter than the provisions in the law. For example, while no minimum OC level is prescribed by the law, the typical minimum committed OC in programmes is 7.5%. Also, regarding liquidity risk, the law now explicitly mandates a 180 day liquidity buffer, but existing programmes already had contractual liquidity protections, albeit for smaller amounts than what is required now.

So, to reiterate: the new law has not had a material impact on the drivers of our rating analysis for OBGs.

Hoarau, Crédit Agricole CIB: Just to clarify one point: interest rates have been rising and the OBG market has been shut for almost a year, so covered bond outstandings have been getting shorter, leading to bigger ALM mismatches. How have those two factors affected OC requirements?

Selvaggi, Moody’s: The shortening of the duration of outstanding covered bonds is a phenomenon that we have seen in various markets, not just Italy. Maybe in Italy this was exacerbated by the lack of issuance.

To your question whether a bigger gap between the duration of the cover pool and the covered bonds increases refinancing risk, the answer is yes. Has this been reflected in changes to OC requirements on our side? No, because our methodology measures and accounts for the risk of deterioration of asset and liability profile, including what we are currently observing, shortening of covered bond durations. For example, the exposure subject to refinancing needs that the methodology takes into account is not only that which is depicted within a given cut-off on a given asset-liability profile; our methodology works with stressed scenarios, in particular, the portion of the cover pool subject to refinancing risk we model is typically higher than 50%. Our refinancing assumptions are set on a through-the-cycle basis, so we generally do not change them in response to temporary market fluctuations.

Another aspect related to the shortening of the duration of outstanding bonds is that we would have taken this into account when determining the programme’s TPI. Hence, if the issuer has discretion to issue shorter covered bonds or do something else that will change the refinancing risk in the structure, this will also be reflected on that end.

So to answer the question, there have not been any material changes to the minimum OC that is consistent with current OBG ratings.

Hoarau, Crédit Agricole CIB: Higher rates have impacted mortgage demand across Europe and led to house price falls in many countries. Have you seen a similar impact in Italy, or has the slower momentum in house prices in recent years meant there was no excessive growth that could now be pared back? Also, are there any signs in your loan book that NPLs are growing?

Villa, Banco BPM: In terms of house prices and the real estate market, we are mainly based in Milan and in Lombardy where the real estate market has been resilient, supporting house prices. As of today, it seems that the real estate market has not been impacted by the interest rate environment. I think there is even upside for prices, especially in residential real estate.

Lucassen, Banco BPM: We are rather cautious in this period because the macroeconomic environment is what it is. We are certainly not seeking to push on growth; rather, we focus on preserving the quality of our loan portfolio in the best possible way. A reflection of this is also that we have seen a significant further increase in the share of loans that are either collateralised or enjoy state guarantees. This is true both for Households and for Non-financial corporate clients, but is even more so as far as small and medium-sized enterprises are concerned.

Hoarau, Crédit Agricole CIB: What about the breakdown of the structure of fixed versus variable rates?

Villa, Banco BPM: In our cover pool, more or less 80% of mortgages are fixed rate. This is a good thing in terms of, for example, being a natural hedge on the liability side. For the Moody’s methodology, it can be a little tricky, though, because this part of the cover pool is now out of the money in terms of pricing because of the higher market rates. But in any case, this is a reflection more or less of the trend that we have seen in our client base for new mortgage business recently, which has been more focused on fixed than on floating rates.

Lucassen, Banco BPM: Putting the situation into perspective, and looking at our performing loan book from a wider angle, of the €105.9bn total of gross performing loans as at 31 March 2023, 59.2% relates to Non-financial companies and 26.9% relates to Households, which are essentially residential retail mortgage loans. These segments together account for more than 85% of the total, with the remainder spread across financials, public sector, non-profit organisations and other.

Sibari, Credem: The Italian case is very peculiar. From our perspective, we haven’t seen a deterioration in house prices yet. What we are seeing is that the Italian government has incentivised the renovation and retrofitting of existing properties via tax incentives, and these energy efficient interventions actually added value to properties. Hence, it’s still too early to see a deterioration in house prices. We’ll probably see that effect when these types of government bonuses end and we return to a more normalised market.

At the same time, we have noticed — and that’s reflected in our cover pool, as well as in our wider loan book — that loan-to-values have decreased slightly overall to an average of around 50%-60%. All of this means that we see very low default rates in the near future. Our cover pool has close to zero defaulted assets, as families have been able to pay their loans and they have not been affected by Covid-19 and the events of the last three years (rise in inflation, Russia-Ukraine conflict, etc).

So right now we are very positive in terms of the residential mortgage market, and we think that this effect may last a bit longer than 2023.

Marlat, Crédit Agricole Italia: Just to add some colour in terms of fixed or floating rates, I would say that historically, the Italian market was characterised by floating rates. However, with low rates, a large part of the market moved and switched to fixed rates up to around 2022. At that point, pricing turned again, and fixed rates began to be more expensive than floating rates. Hence, customers looked to move back to floating rates again. What we did was revive a product that we have used a lot in the past, floating rate loans with a cap. We did it in order to avoid rising credit risk further down the line as customers are faced with higher monthly instalments. After all, right now, the default rate is really low, around 0.5% at market level. Floating rate mortgages with a cap are something that are natural for our clients but are not a game-changer for the bank because we hedge ourselves in the market. At the end of the day, it means that something like 59% of our new mortgage production in H2 2022 has been done via floating rates with a cap.

Hoarau, Crédit Agricole CIB: What is Moody’s view on the real estate market and to what extent it can affect ratings? Are you focusing more on the market and refinancing risk, or the situation in the real estate market and impact on loan quality?

Selvaggi, Moody’s: Let me start by saying that the cover pools represent a positive selection vis-à-vis the overall mortgage market. This is not only driven by the programmes’ eligibility criteria, but also by issuers’ practice (for example, non-performing loans are usually repurchased by originators). The drivers of credit loss of the individual mortgages that we find in the cover pool can be summarised under two aspects. One is low LTVs, on average around 50%, and the other is long seasoning. The combination of the two makes the credit quality of Italian cover pools reasonably high.

Regarding the evolution of collateral pools in terms of the split of fixed to floating, we’ve seen an increase in long term fixed rate loans — I think the spectrum varies between 30% and 80%. The main driver of OC is indeed the market risk associated with the cover pool rather than the expected credit loss, as mentioned earlier. In a scenario in which you have to potentially sell the cover pool to repay the obligation (for example a “fire-sale” scenario), a fixed rate loan is less valuable than a floating rate loan in a rising rates scenario. On the other hand, the performance of mortgages is of course better when fixed because these are immune to higher interest rates.

The only thing which I would add on the housing market is that even in case of a slowdown of prices, we do not expect this to be disruptive in Italy, largely because house price growth in Italy in the past years has been quite slow compared to other markets.

Hoarau, Crédit Agricole CIB: Turning to the investor side, the last 12 months have been quite eventful. How has the new yield as well as risk environment affected your asset allocation towards covered bonds?

Alberto Pisana, Allianz Global Investors: The main trigger for a change in our allocation to covered bonds has clearly been the higher absolute yields of the asset class, but the low beta has also helped. We come from a period where the allocation to covered bonds was decreasing. This trend has clearly stopped and it is now starting to increase for certain accounts. The decisions by the ECB are also playing a role, of course, because we are seeing a decompression trend which started last year and is continuing. In turn, this means we are also becoming a little more selective on issuers and jurisdictions. We are happy to have done our homework in the past where there was almost no discrimination across issuers. We have analysed the fundamentals, or the differences in fundamentals across issuers and jurisdictions, as well as their respective legal frameworks. We are happy to finally be able to apply this know-how now and get paid for it with wider spreads.

Peter Benschop, BNPP AM: Our view of the asset class has turned much more positive and this obviously has to do with the regime change. We had the ECB for years and years, they crowded out real money investors when there was little supply to begin with, yields were negative in many cases, spreads very tight. The result was that there was little interest among investors and the asset class fell out of favour. Now, with the ECB retreating, rates are higher and asset swap spreads wider, making absolute yields of covered bonds overall much more interesting. So what we did during the second half of last year was to start building up a position in covered bonds again, coming from an underweight position. We mostly used the primary market and have continued to do so this year. So we are more positive on covered bonds.

Having said that, the short term is really our preferred spot. Up to five years, we are very interested if there are new issues. We also look at longer tenors, but it all depends on the shape of the swap curve and the curve inversion makes longer dated bonds relatively less attractive, so the curve shape is a bit of a hurdle. We’re still looking at covered bonds up to 10 years, but regarding tenors beyond 10 years, we clearly prefer European Union bonds.

Stéphane Taillepied, Amundi: For us, the main point is the appetite for short term duration, frankly, particularly for covered bonds. We expect around €200bn of overall covered bond new issuance this year. But the duration is currently below the historical average, and for Amundi in particular, we are quite reluctant to look at issuance above five years because of the very low visibility both for macro but also micro issues.

We have been quite surprised to have no issuance from Italy because there is a strong improvement in the sector’s profitability, banks have low levels of non-performing loans, average LTVs in cover pools are very low. I don’t know what could happen in the second half, because investors are expecting around €30bn of issuance. Maybe that’s realistic, but it’s a lot.

Hoarau, Crédit Agricole CIB: Let’s indeed focus specifically on the OBG market now and how our investors position the segment versus its European peers. Alberto, you highlighted spread differentiation and that you can now focus on relative value again. How would you position, or reposition OBGs in this investment universe?

Pisana, AllianzGI: There are different metrics one can look at. The first, in my mind, is the comparison with BTPs. It’s true that in a market that has been driven by the ECB, we’ve seen BTPs trading very cheap relative to OBGs, which was not really normal. The spread between the two has by now tightened a lot. Still, it would be difficult to justify an investment in OBGs when they are maybe 20bp more expensive than BTPs, taking the five year point or a bit longer. We are coming from an era where many real money investors had to reduce their exposure to BTPs. They may now have a little bit more space to add BTPs and less forced to buy OBGs as a replacement. At the very short end, we like the current situation where covered bonds sometimes pay higher spreads than senior unsecured bonds. At the end of the day, when you’re managing an aggregate fund and you can enjoy an overweight in OBGs against senior debt at the short end, you can also accept being underweight them against BTPs in longer tenors.

Within the covered bond asset class, historically we would have likely looked at cédulas from Spain or Portugal. If we have to do this exercise now, when there will be new issues coming from Italy, we need to acknowledge the fact that the Italian market has been dormant for some time. Hence, we have less visibility on the Italian market than we have on Spanish or Portuguese names. So if Italian issuers are targeting the belly of the curve, that’s really the starting point. However, we would need a higher premium, at least for the first issuances. You’re seeing other jurisdictions coming to the market with levels in the 40bp area, or a Nordic name in the seven year space pricing at 30bp today, for example. So these numbers are more or less the expectations for the lower bound of a possible price discovery for OBGs.

Taillepied, Amundi: There are many positive points for Italy. OC is quite strong, around 35%-40%, NPLs in the covered pool are below 1%, and we have more visibility on the mortgage market in case of a recession in Italy than for the rest of Europe. So we have many positive points. I think there will be great interest from investors in the event of new issuance. I agree there will be a premium for the first issuance, because there was no issuance for almost a year. However, I do think that versus Nordics, even versus Spain, there is room for issuance for the near and medium term.

Benschop, BNPP AM: We look at Italian curves and obviously it’s a unique situation compared to other jurisdictions. The OBG curve is far flatter than the BTP curve, and OBGs are more expensive, from around the four to five year point, so we’re making this trade-off for portfolios that can do either sovereigns or covered bonds. In terms of valuation, I agree there definitely has to be a premium. If you look at outstanding Italian covered bonds, many of them are quite old and illiquid now, so I’m not sure they are very good reference points for valuing new issues. You would therefore look at Spain and it definitely needs a decent pick-up against those.

Hoarau, Crédit Agricole CIB: I believe there is no doubt around the table that when we open the market issuers will have to put the right price on the table and cannot afford failure early-on, but a lot of price discovery will be involved. Florian, how would you position OBGs in a relative value scheme?

Eichert, Crédit Agricole CIB: As has already been mentioned, secondary levels are inconsistent and irrelevant when it comes to pricing new issues. Take a historically large OBG issuer such as UniCredit: they have not been active for years and the longest benchmark OBG they have outstanding is a 2026. To be fair, the difficulty of taking secondary references for pricing new issues was also there when many other markets reopened issuance in 2022 and 2023, including Spain and Portugal.

Hoarau, Crédit Agricole CIB: Also because the Eurosystem is distorting things.

Eichert, Crédit Agricole CIB: Yes, CBPP3’s ISIN limit is at 70% and I’m pretty sure they are very close to this for many Italian issuers, as they are for the older vintage Portuguese and Spanish covered bonds. Hence, free float is negligible. So you reference other jurisdictions that have priced new issues more recently, and the ones that come to mind are Spain and Portugal, where we’ve seen supply fairly recently. From Spain, Santander re-entered the cédulas market via dual tranches and the issuer has by now created live points in the three, five, seven and 10 year tenors. These levels alongside a Santander Totta five year would clearly be good starting points for any OBG issuance. In the past, you would have had OBGs pricing around the same levels as strong Spanish issuers. However, if we factor in supply, with Spanish banks having issued a lot already, while out of Italy we are only getting started, your starting point is clearly wider. If we are talking about, say, five years, Santander Totta plus 5bp could be something to focus on for the first issue out of Italy, and if it goes well, we could quickly move inside Portugal and start moving towards cédulas levels. Of course, just which issuer we are talking about is extremely relevant. UniCredit or Intesa? Or rather smaller issuers? Italy is a much more diverse country than many other jurisdictions when it comes to the issuer universe. Hence, the most interesting bit to me is rather going to be where you price second tier names. In the secondary market, we currently see a good 15bp differential between Intesa in five years at plus 20bp and some of the second tier names in the mid-30s. Whether this gap is similar in the primary market, whether it needs to be 20bp or 25bp, that’s what’s interesting, and this is where syndicates will really prove their worth.

Hoarau, Crédit Agricole CIB: At the beginning of the conversation we mentioned the keyword, namely differentiation. We had a phase where for a decade spreads were compressed to the extreme but we are now evolving into a very strong decompression phase and the difficulty is to price the credit differential. Bookbuilding will play its part, but there is still a very strong price discovery element involved, while the supply element across the board, across jurisdictions is certainly also going to further impact pricing for the entire segment.

Eichert, Crédit Agricole CIB: As we’ve seen this week and last, if you have too much issuance in a short period of time, demand may not always be there, even though absorption capacity structurally is there. So if Italian issuers manage to coordinate between pre-summer and post-summer, with the large issuers setting pricing references that can then be used for the second tier issuers, then I’m fairly confident on the outlook. But if you have too many issuers jumping into the pre-summer period, maybe also second tier names with tenors that are too long for investors, then you could indeed have accidents. And if you have an accident in this market-reopening period, that will set the scene for whatever comes after the summer. Therefore, it is super-important that to the extent that issuers can, there is coordination amongst them to not overwhelm the market.

Because, size-wise, around €10bn of OBG benchmark issuance between now and year end is well absorbable. It’s more about coordination, avoiding short term indigestion symptoms, and getting the tenor choices right. After all, we have heard from Peter, Stéphane and Alberto that it’s not necessarily the 12 to 15 year part of the curve where issuers will find the bulk of demand, yet we have in the past had issuers from Italy that have typically tried to term out funding as much as they can via OBGs. For me, those are the pressure points that will also determine the differentiation across issuers, and they can quite easily move this from 15bp to 20bp or even to 30bp.

Hoarau, Crédit Agricole CIB: Stefano, Crédit Agricole Italia has been a specialist in issuing 15, 20 or even 25 year tenors. What can you accommodate when you hear investors saying that they’re happy up to five years, more careful with seven years, and unsure whether there is a market for longer tenors than that? Personally, I’m a bit more optimistic in this respect. For insurance companies, for example, I believe there is a structural need for duration in this market.

Pisana, AllianzGI: Yes, there is, but you do have alternatives to covered bonds in other asset classes.

Hoarau, Crédit Agricole CIB: True, there are certainly alternatives, and in that case we are back to pricing. But we have seen Deutsche Bank successfully issuing a 10 year benchmark Pfandbrief while some others were struggling to close their books on shorter tenors. I believe that if the right name were to come with a 12 year benchmark, it would go nicely. I’m not talking about 15 or 20 years. Obviously the issuer will also pay a little bit of the credit curve, maybe something in the mid-single digit context for the 10s-12s curve. After having seen €110bn of supply in the three to five year part of the curve, I’m sure that if a very prime name out of the Nordic region or Netherlands came to market with a 12 year deal, it would work.

But going back to my question to Stefano, how will you manage things? Because indeed at the end of the day, it’s more five years, potentially seven years, that people would like to see, while you are clearly not keen to do a three to five year.

Marlat, Crédit Agricole Italia: At the beginning of our discussion, I mentioned the crowded market early in the year, with the heavy concentration in short maturities. I also noted that I’m not sure we would have been there even had the regulation already been in place. And the rationale is the same now. We are not looking for cash, we are looking to manage our liability structure, and at the same time, we have to pay back

TLTRO III liquidity in June like everybody else. In June we also have a maturity of an outstanding covered bond benchmark. From my point of view, we currently have enough excess liquidity to pay both back without having to access the market. Our idea has always been to be a frequent issuer, as we promised to the market from 2014. However, at the same time, it is crucial to be free to choose and not to be obliged to fund our needs on the market. Like you say, to cut a long story short, if you take a look to our yield curve, I think that anything shorter than seven years doesn’t make sense for us.

Hoarau, Crédit Agricole CIB: Stefano and Francesco, what can you tell us about what could make sense for you in this respect?

Sibari, Credem: Well, I think we have a lot of elements on the table right now. We are definitely evaluating how to access the market relative to what our needs might be and what investors’ expectations will be. The price discovery phase will be fundamental, among all factors. As Stefano was saying, a lot of banks have an excess of liquidity, so they can take their time in approaching a potential window to access the market. At the same time, Italian banks have been looking at the stability of liquidity indicators such as LCR and NSFR. It will be crucial to see where these ratios land after banks have repaid all the TLTROs. If ratios might be too low, in that case banks might privilege longer tenors, around five or seven years, to maintain stability and flexibility over time in their liquidity position. At the end of the day, many factors will need to be evaluated and taken into account to determine the duration of new issuances of covered bonds, which will also depend on market conditions.

Villa, Banco BPM: We would replicate a little of what we had in mind last year, when we placed a five year covered bond in the market and then planned to do another transaction with a longer maturity. Assuming that we have two transactions in our plans for 2023, the best approach would be to go for a first trade with a tenor no longer than five years, and we would then plan to go longer in the second part of the year with the second transaction that we have in our funding plan. So, this is mainly our strategy in terms of maturity.

Hoarau, Crédit Agricole CIB: Back to the buy-side, to what extent could the ESG angle change or influence your view or perception towards investing in OBGs in the coming weeks or months?

Pisana, AllianzGI: Well, ESG has by now been a crucial topic for years. All our ESG analyses and considerations are already embedded in our investment process. Hence, from my point of view, there is not much difference between a conventional and an ESG covered bond. We focus on the issuers and, as such, we are pretty much aligned with the ECB guidelines when it comes to greening their balance sheet. What I have also been saying to issuers in the past is that a green label may be necessary but not sufficient to show the ESG quality of a cover pool. So for me, it’s a more holistic assessment that I apply to the issuer and not only to the bond.

Taillepied, Amundi: In 2021, ESG covered bond issuance represented around about 15% of all issuance, and year-to-date it is below 10%. However, irrespective of these volumes, I completely agree with Alberto, the quality of the issuer is the priority for investors.

Benschop, BNPP AM: ESG is fully integrated into our investment process, too. Issues in green or social formats are very interesting to us. We have large green bond funds, also a social bond fund, that are growing nicely, and they cannot buy anything that’s not green or social. So we’re looking for paper, and covered bonds in one of those formats would broaden the range of portfolios that participate in the deal.

Aside from that, all portfolio managers are incentivised to buy green bonds. Every issuer has an ESG score, and our portfolios have to beat their respective benchmark’s average ESG score or, if that’s not possible, the average score of the relevant investment universe. Green bonds, but also social bonds get an ESG score uplift, and thereby help portfolio managers to improve the ESG score of their portfolio. So yes, green bonds and/or social bonds are indeed interesting to us.

Hoarau, Crédit Agricole CIB: Francesco, Banco BPM has issued green covered bonds. How are you going to, let’s say, orchestrate your ESG issuance strategy in the context of the re-opening of the OBG market? Is it something you are considering?

Villa, Banco BPM: Yes. Last year we issued around €2bn of green bonds, including €750m of covered bonds. When we issued these covered bonds in March 2022, the green label helped us greatly reduce execution risk in a very tough market, with the war in Ukraine having broken out shortly beforehand. Without this label, it would have been very difficult to reach €750m, so the project was a great success in terms of size.

But while using the green label for covered bonds is an option, it typically suits the senior space better, and we also have senior bonds planned for this year. We are also updating our green bond framework, in order to align it with the EU Taxonomy, and these updates have an impact on the categories within our framework, in some cases further limiting the potential capacity. So green OBGs are an option, but we have to carefully manage our green bond issuance capacity.

Sibari, Credem: We established our ESG bond framework in 2021 and last year we were very active in the bond market: we issued our first green senior preferred, and we then became the first Italian bank to issue a subordinated social bond. As part of our funding strategy, ESG formats are fully integrated into our funding plan, and when the domestic covered bond market will reopen it will be possible to consider an ESG transaction also for this asset class in either the green or social format.

In 2022, ICMA released a significant update to the section relating to Secured Green and Social Bonds broadly in line with EBA’s recommendations. According to this update, new categories of ESG transactions could be implemented: a Secured Collateral Bond, which is where the use of proceeds are applied exclusively to the related collateral pool; and a Secured Standard Bond, which is where the use of proceeds are applied to other assets of the issuer. This amendment has removed an obstacle for the covered bond market which limited the issuance of new covered bonds to the amount of ESG assets within the cover pool and to financing and/or refinancing only specific ESG categories such as green buildings or social housing. Thanks to ICMA, issuers now have greater flexibility for future issuances and a broader range of assets and ESG categories to pick from and apply their use of proceeds. It is possible that in the future we might see an increase in green and social covered bonds in these two different formats.

But I agree with Francesco that it’s more efficient to use the green format for senior unsecured debt. It usually adds traction to investors’ demand and, in the end, creates more value for the issuer. Nonetheless, the reopening of the domestic covered bond market will influence ESG funding strategies and the sustainability of ESG portfolios will become a key factor in the choice of the type of bonds to issue.

Marlat, Crédit Agricole Italia: We have been the first to issue a green OBG, and it’s interesting that we also have Banco BPM around the table today, as we are the only two to have done so.

We issued because we wanted to, not because it was convenient — it was a lot of work, after all. We have often thought about a second issue, but in Italy the buildings are on average very old. Hence, to achieve eligibility for the taxonomy, we did an update — again, a lot of work. The bottom line is that you need new houses, and if you need new houses when you already have a lot of old houses, you need to use new land, and it’s an idea that we do not like so much as it doesn’t feel so green. Hence, what we are trying to do is to focus on the restructuring of existing properties where we can achieve an upgrade in the energy class. However, when doing this, you encounter challenges: usually, we have the new updated energy performance class after the upgrade, but very often we do not have the old class in the system, and this makes it difficult to calculate the extent of the upgrade. This is really a challenge. I don’t know if we can solve it, but the concept of retrofitting and upgrading for us is much better than using new land.

Hoarau, Crédit Agricole CIB: Does anyone have any final comments or questions?

Pisana, AllianzGI: As we are all expecting these new OBG issues and we know there is this 30 day Bank of Italy notification period, can the issuers say anything on whether this has been done and hence on what date you will actually be ready to start?

Villa, Banco BPM: We have done our homework, we have gotten our internal approvals, and we have made the application to Bank of Italy. So, we think that by the middle of June we can see the market reopen and we will be ready.

Sibari, Credem: We are still doing our homework. We have been working on the internal approvals and the update of the documentation, so we are more looking at a window starting from September — not the first window, because we also want to see how the market will open.

Marlat, Crédit Agricole Italia: We did the same. We had our board of directors meeting and we sent all the documentation to Bank of Italy that they had asked for. Hence, if they do not ask us for anything else, we will be past the 30 day period during the first part of June. We still need to supplement the prospectus, though, which will take another five to 10 days or so. I hope to be able in June, maybe from mid-June, to see how the market is. At that point we will then choose our best strategy.

Please click here to download the roundtable in pdf format.

The new issue is the first euro sub debt from an insurance company or bank since 7 March, after which the crises of Silicon Valley Bank and Credit Suisse put paid to issuance plans. The French insurer’s deal is also the first subordinated insurance trade in euros since 11 January, when CNP Assurances sold a €500m 30.5 non-call 10.5 sustainable Tier 2 debut.

With a view to managing its call schedule over the coming years, Axa hit the market this morning with initial price thoughts of the mid-swaps plus 295bp area for the 20.25 non-call 10.25 benchmark, expected ratings A2/A- (Moody’s/S&P). The size and spread were then set in one step at €1bn — the issuer’s target size — and 260bp on the back of €3bn of demand, and the order book good at re-offer totalled €4.6bn.

André Bonnal, FI syndicate at joint bookrunner Crédit Agricole CIB, said the lack of insurance supply played in Axa’s favour, in conjunction with an emergent duration bid and the issuer’s strong profile.

“The trade worked out beautifully,” he said. “We had the feeling that the bid for duration would be very strong, given that the market now believes terminal rates are going to be reached sooner rather than later, and these kinds of yields are likely to disappear, so it makes sense for investors to load on duration. That really helped the transaction as well as the scarcity value that has been building alongside modest supply expectations in regards to insurance.

“We had all of the big asset managers that count in insurance sub in the book and could even have fully allocated the transaction with the top six counts alone.”

The leads saw fair value at the mid-swaps plus 250bp area, citing Axa 4.25% 2043 non-call 2032s at 245bp and taking into account the short curve extension. The leads’ fair value calculations were done on an i-spread basis to the reset date rather than the first call date, i.e. putting it at a tighter level than might otherwise have been seen.

“Ultimately, there was a strong consensus that this was going to be a successful and attractive trade even at 260bp,” said Bonnal, “which is just 10bp of new issue premium — quite skinny, if you consider the turmoil we have seen in the market.”

The performance of insurance debt since the failure of SVB and emergency takeover of Credit Suisse had earlier suggested investors were acknowledging the sector’s differences to the banking industry. The iBoxx Insurance Subordinated index, for instance, outperformed the iBoxx Euro Banks Tier 2 index in the wake of the US bank’s collapse, and went on to trade inside its bank counterpart as fears over the Swiss bank mounted (see chart over).

“It makes sense that we’ve seen this outperformance,” said Bonnal. “Just as the EU banking sector was never really in the same situation as the US banking sector, the insurance sector is clearly further away from being in a similar situation.

“The illiquidity of the insurance sector has also played a little bit in favour of insurers,” he added.

Insurance paper could not, however, fully escape the market turmoil, with Tier 2 debt early this week still some 20bp-30bp wider than pre-SVB, while Restricted Tier 1 (RT1) were two to four points lower on a cash basis after a substantial rally since last week, having traded as much as eight to 10 points lower after news of the write-down of Credit Suisse AT1 emerged.

“Clearly the market was hurt,” noted Bonnal, “but similarly to the rest of the financial sector, there hasn’t been any panic-selling; this was a remarking exercise that has now stopped and we are already closing on the pre-SVB levels across the capital structure.”

Insurance differences supportive

The write-down of some $17bn of Credit Suisse Additional Tier 1 (AT1) has nevertheless led to increased scrutiny of not only deeply subordinated bank instruments, but also their insurance counterparts, namely RT1. Investors are keener than ever to understand the fine print of both the structural features of the instrument, and the resolution process issuers would face.

Furthermore, insurance companies are far from immune from the impact of the sharp increases in yields that were at the centre of the failure of Silicon Valley Bank (SVB).

According to Michael Benyaya, co-head of DCM solutions and advisory at Crédit Agricole CIB, the insurance sector offers comfort on all three fronts — rates, RT1, and resolution — even if there are risks that need to be understood.

“Rising interest rates are viewed as a positive for the insurance sector, especially the life insurance sector” he said. “But it’s not 100% positive.”

Life insurance companies are exposed to rising interest rates: on the asset side — e.g. unrealised losses on bonds; in their liabilities — the risk of policyholders trying to redeem policies early, i.e. “lapse” risk; and through derivatives exposures, via margin calls.

“We saw that as of year-end 2022, IFRS equity massively decreased last year due to increasing unrealised losses on bond investments,” said Benyaya, “while Solvency 2 sensitivities show that a further increase in rates versus end-2022 levels would be marginally positive or even negative for some insurance companies. So far, these are just accounting moves; the question is whether insurance companies would have to crystalise these losses and sell such bonds to meet policyholder redemptions.

“But lapse risk is generally very low and manageable — insurance liabilities, including life insurance policies, are not usually very liquid. It’s not that straightforward to redeem early a life insurance policy and there could be penalties attached or a loss in the tax benefit. So the prospect of a bank run-type scenario for insurance companies is still pretty remote.”

Italian life insurer Eurovita was nevertheless placed into extraordinary administration last week after Italian insurance regulator IVASS had in February placed it into temporary administration and suspended redemptions of its savings policies following a high volume of surrender requests. The company had also deferred interest payments on two Tier 2 bonds based on mandatory deferral clauses and its weak financial position.

Fitch said last month that Eurovita’s fate highlights the risks that rapidly rising rates can pose to weaker insurers, but noted that its circumstances are different from those of other life companies, including its compatriots’.

Regarding resolution, a key difference between AT1 and RT1 is that the insurance instruments generally only contain a loss absorption trigger based on solvency requirement ratios (the Solvency Capital Requirement (SCR) and/or Minimum Capital Requirement (MCR)).

“With the exception of the Netherlands, there is no bail-in regime applicable to insurance companies,” said Benyaya, “so there is no statutory loss absorption provision included in RT1 terms and conditions.”

An Insurance Recovery & Resolution Directive (IRRD) akin to the Bank Recovery & Resolution Directive (BRRD) is in the making in the EU, which could be implemented in 2025-2026. This will introduce a bail-in power, amongst other resolution tools, for supervisors, who will hence have the power to impose losses on bondholders in the context of an insurance company resolution.

“However,” noted Benyaya, “this clearly states that any bail-in will be subject to the ‘no creditor worse off’ (NCWO) principle and therefore applied as per the hierarchy of claims — as enshrined also in the BRRD.”

RT1 or Tier 2?

Going forward, the insurance sector could draw support from its limited size and ongoing modest supply expectations. The circa €20bn-equivalent of outstandings in the RT1 sector, for instance, are dwarfed by the circa €250bn AT1 market, and in a first quarter when euro bank issuance has been breaking records, only two subordinated insurance euro deals have been launched before today — a €750m 10 year senior issue from Axa and CNP Assurances’ €500m Tier 2 sustainability debut (joint bookrunner Crédit Agricole CIB), both in the opening fortnight of January.

Less than €15bn of insurance sub debt is coming up for redemption or call this year, but ahead of the market’s recent disruption, a pick-up in RT1 supply had been deemed possible in light of an increase in redemptions and calls in 2024 and 2025, in particular related to legacy perpetual grandfathered Tier 1 debt issued in 2014 and early 2015.

“In an ideal scenario, a few insurers would have been looking to pre-finance these bonds early with RT1,” said Bonnal. “But even if the RT1 market has outperformed AT1, overall levels are wider than a month ago, and issuers might want to wait a bit and potentially see AT1 supply before themselves testing appetite from investors in deeply subordinated bonds.

“The big question is what kind of split are we going to have between Tier 2 and RT1?”

Indeed, Benyaya expects that, with Tier 2 capacity available, a number of insurers could fall back on the less junior instrument for refinancing the legacy Tier 1 rather than seek to raise RT1, but that many will wait before taking a decision.