European Banks’ Regulation: A New Opportunity in Credit? by Jorgen Kjaersgaard, AllianceBernstein
Posted by Jorgen Kjaersgaard and Steve Hussey of AllianceBernstein Holding LP (NYSE:AB)
European banks are issuing new subordinated bonds that can be written off in a crisis. For investors who are willing to take the risk, our analysis suggests these bonds may provide a way to beat the low returns in today’s corporate bond market.
These subordinated bonds were drawn up as part of new Basel III regulations. They’re a response to the 2008 financial crisis, which saw taxpayers mainly foot the bill for bank bailouts while bondholders were left largely untouched. These new bonds are designed to soak up losses by converting to equity, or being written off entirely, if a bank’s capital ratio were to fall below a predetermined level.
In other words, bondholders would assume a healthy share of the losses, unlike the last time around. In theory, this development should help banks keep their operations going in a crisis while safeguarding the stability of the financial system.
This market is in its infancy. But it stands to grow substantially.
Supply Set to Spike
In our view, the greatest opportunities lie with Additional Tier 1 (AT1) debt capital, the first bonds that would take a hit when a bank runs into trouble. Tier 2 contingent convertible bonds (CoCos) also offer some opportunity—as with AT1, these would convert to equity at a predetermined trigger point. Tier 2 CoCos have specific maturity dates; AT1 securities are perpetual, though they do have a call date when issuers can take them back.
So far, European banks have issued the equivalent of US$31 billion in Tier 2 CoCos and $50 billion in AT1 debt. Europe’s large banking sector means it will account for a large share of future global issuance, too (Display 1).
The bonds won’t appeal to everyone, but their yields may compensate investors for the risk of losing their money. BB-rated European AT1 bond yields average 6%, which is above similarly rated high-yield corporate bonds and about the same as junk bonds rated CCC (Display 2).
Improved Outlook for Banks
One way to look at the risk-adjusted assessment is to consider how our analysts estimate potential losses. The mandatory write-down and conversion-to-equity provisions mean investors would likely lose more in a default than they would with most conventional corporate bonds. However, our research suggests the probability of default has come down.
Why is default less likely? For one thing, banks have reduced the risk on their balance sheets since the crisis and built up equity capital as a cushion against losses.
Meanwhile, the European Central Bank provides implicit support by keeping monetary policy loose and standing ready to offer cheap funding if the going gets rough. We don’t think that’s likely to happen to the European banking sector as a whole—not with the euro area economy in the early stages of recovery.
Be Prepared for Volatility
There are, of course, risks to be aware of. The 2013 nationalization of Dutch bank SNS Reaal wiped out shareholders and subordinated debt holders alike. There are also plans to force losses on bondholders of Austria’s Hypo Alpe-Adria-Bank. Both are reminders that some banks do fail.
Investors should also keep in mind that regulators don’t need to wait for capital ratios to fall to predetermined levels before they suspend coupon payments on AT1 debt. They can act early if they think a firm may be headed for trouble. We’re not sure markets have priced in this risk yet. These risks should be accounted for, although in our view the compensation would still be relatively attractive.
What’s more, the dominant buyers in this market so far have been high-yield mutual funds, followed by hedge funds and private wealth managers. But that money can flow out as quickly as it flowed in. So, trading could be volatile until insurance companies and other big institutional investors with long time horizons become steady buyers.
Careful Credit Selection Can Pay Off
We think there are appealing opportunities in this market for investors, provided they do their credit homework. Given the tight spreads in the credit market today, we generally prefer AT1 issued by retail-oriented banks. Their less volatile business models mean they aren’t as likely to burn through their capital buffers as their commercial and investment bank peers. However, if spreads widen, commercial and investment-bank debt may present a buying opportunity.
For investors who can withstand some bumps in the road, there’s a good chance this new wave of securities may offer a way to boost returns in today’s low-yield environment.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.
Jorgen Kjaersgaard is Head of European Credit Portfolio Management and Steve Hussey is Head of Financial Institutions Credit Research, both at AllianceBernstein.