* Widening spreads may force bank to leave bonds outstanding
* Extension yet to be tested in AT1 sector
By Alice Gledhill
LONDON, Oct 5 (IFR) - Two Santander AT1 securities have sharpened the market’s focus on extension risk, leaving investors guessing whether the bank will exercise upcoming call options - an assessment muddied by its aggressive behaviour towards bondholders in the past.
Extension risk, the possibility that a borrower may leave a callable security outstanding, has become an increasingly important driver of AT1 valuations.
While it was all but inevitable that the first vintage of bonds would be called due to their sky-high reset spreads, it is much less clear cut for the deals that followed.
Santander’s AT1 debt is where concerns are most acute. It has €1.5bn 6.25% and US$1.5bn 6.375% AT1s callable in March and May 2019 respectively, with reset spreads of 541bp and 478.8bp over the prevailing mid-swap rate.
The dollar note is bid at 532bp over swaps, implying it would be costlier for Santander to refinance that bond than to leave it outstanding. The euro is bid at 504bp over swaps, but traded wide of its reset at 560bp over swaps in August.
The sector proved resilient when Banco Popular’s AT1 debt was wiped out last year, the first such instance. It similarly shrugged off the first coupon cancellation in the case of Bremer LB, but no AT1 bond has yet been extended.
Santander has extended subordinated bonds in the past, and investors have not forgotten its aggressive liability management exercises in 2011 and 2012.
“It has got to be a risk,” said one portfolio manager.
“The treasury team are slightly more friendly than they used to be, but I’m not sure whether that leopard has changed its spots. I think there is a lot of call risk not priced in. But to me, investors shouldn’t be surprised if people don’t call - it’s very plain what this security is.”
Second-guessing Santander is complicated by the fact that it is not a purely economic decision - reputation is also a factor. Added to that, each bank’s regulator must give the green light to call, ensuring refinancing costs are not too punitive, though some countries are likely to be stricter than others.
Funding officials should seek permission to call around three months prior to the call date, bankers said. New issuance in the coming months would imply that Santander intends to redeem the bonds.
“I imagine Santander will seek approval and at the same time monitor the market to see whether it makes economic sense to call the bond,” a banker said.
Filippo Alloatti, senior credit analyst at Hermes Investment Management, believes there is a 60/40 probability Santander will call and refinance before year-end.
The bank is unlikely to want to be the first large European bank not to call an AT1, he said, particularly since it is highly reliant on the wholesale debt market. It had €162.6bn of debt securities outstanding as of June 2018, according to its latest fixed income presentation.
The fact that Spanish peer BBVA raised €1bn of AT1 inside 6% last month may also galvanise Santander into proving its own market access.
“It would be a pretty punchy decision if they decide not to call,” said Alloatti. “ to be clear, it’s totally their discretion, I’m not saying they should.”
Failure to call would likely trigger a knee-jerk sell-off, particularly among the lowest coupon deals with slender reset spreads.
Indeed, concerns around extension risk are already visible in their trading levels. Belfius’s €500m 3.625% NC April 2025, which priced in January and resets at just 293.8bp over mid-swaps, is now bid in the low 80s, for example.
But hopes are high that the sector would weather it well. It helps that Santander’s €1.5bn 6.25% is callable on a quarterly basis following the initial call date, which would mitigate the market’s perception of how long they could be extended for.
By contrast, longer call intervals are generally seen as negative to the extent that they ‘guarantee’ a minimum period during which the bond will be extended at a below-market spread.
Standard Chartered for example extended a US$750m 6.409%legacy Tier 1 in 2016, prompting a 13 point price fall given its reset spread of three-month Libor plus 151bp. The bond is only callable every 10 years. Santander’s US$1.5bn 6.375% AT1 is callable every five years.
One major AT1 investor is reportedly expecting issuers to refinance so long as a new issue would price within 50bp of the old security’s reset level. It is unclear whether that incremental cost should include issuance costs such as legal fees, or relates solely to the market level.
“From a bank’s perspective, they should also be looking at the economic value of holding excess CET1 rather than issuing an AT1,” said the first investor. (Reporting by Alice Gledhill, Editing by Helene Durand, Julian Baker)