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REFILE-First call or perpetuity? AT1 comes full circle
August 25, 2017 / 9:56 AM / 3 months ago

REFILE-First call or perpetuity? AT1 comes full circle

(Clarifies coupon reset in para 6)

* First round of AT1 bonds up for call in 2018

* Cost to be overriding factor in decision to call

* Investors must second-guess issuers to avoid losses

By Alice Gledhill

LONDON, Aug 25 (IFR) - The first wave of Additional Tier 1 bonds are coming up for call next year, but while the earliest trades from 2013 are all but certain to be redeemed, the true test is not likely to come until 2019.

Some €77bn-equivalent of AT1 and grandfathered Tier 1 instruments could potentially be refinanced in 2018-2020, according to BNP Paribas data.

Banks are already grappling with how best to manage their redemption profiles, while investors must ensure they are positioned correctly to avoid potentially heavy losses from bonds repricing.

Market convention is that AT1 bonds are priced to the first call date, but investors started paying closer attention to the yield to perpetuity when the sector tanked in the first quarter of 2016.

There are rules that govern an issuer’s decision to call or not - AT1 bonds were designed following the last financial crisis to shore up balance sheets with loss-absorbing capital, and an issuer must get the nod from its regulator before a call. But the key consideration is the cost of replacement capital.

Where an AT1 bond is not called, its coupon resets to the original credit spread. Spreads for the first deals were very high, but a huge rally means the majority of European AT1s are now trading much tighter than their reset levels.

For instance, BBVA’s US$1.5bn 9% perp callable May 2018 - the first AT1 bond sold - would reset to 826.2bp over five-year mid-swaps in nine months, but it now trades at a 3.69% yield-to-call or 223bp over swaps, according to Thomson Reuters data.

“With the market being so strong today, you would call, but what if the market in a year or two is a bit weaker, and actually it’s marginal whether you’re saving any money versus keeping the AT1 outstanding?” said Kapil Damani, head of capital products at BNP Paribas. “Would you still call?”

Though more than 12 months away, 2019 is shaping up to be more of an acid test for the market, said Steve Hussey, head of financial institutions credit research at AllianceBernstein.

“The economics of the deal is the all-important thing, and depending on where rates are - but let’s assume they’ve ticked up a bit from here - it would probably make sense to leave a lot of those deals outstanding, given much lower resets than (on) the 2018 callables.”

CALL ME, MAYBE

But there are other factors at play that muddy the waters both for issuers and investors.

In the past, the assumption has always been that issuers will call bank capital to avoid irking bondholders.

But although regulators have implemented strict rules governing the marketing, issuance and call schedules of AT1s to reduce the incentives to redeem, that assumption arguably still lingers.

“Whilst in theory you’ve got these constraints on issuers, and they’re completely free not to exercise their calls, investors do continue to expect a bank to call the bonds on their first call date,” said Tom Grant, a partner at Allen & Overy.

“If a bank doesn’t call, it would still be a noteworthy event.”

FAR FROM CLEAR CUT

That was certainly the case last year when Standard Chartered said it would leave a US$750m legacy Tier 1 bond outstanding; it immediately plunged 13 points to 84.

It served as a timely reminder that banks are willing to take a reputational hit and triggered a sell-off in similar securities as the market repriced.

On top of that, there may be instances when banks refinance even if it is more expensive than leaving the old securities outstanding. For example, issuers may wish to change the structure, currency or call duration of their outstanding AT1.

“That’s when it becomes really interesting,” said Damani from BNP Paribas.

“What will the conversation with the regulator be like, and in situations where it’s wider than the reset spread, will there be reasons that issuers can use, or situations that will allow refinancing in a situation where the replacement instrument may be more costly?”

MAKING THE RIGHT CALL

Issuers are not allowed to warn in advance of their intention to call a perpetual bond, forcing investors to make their own assessment. If they make the wrong decision, it could be an expensive mistake.

The worst scenario would be where a bond with a low reset spread is trading tight on expectation of a call, but the bank surprises the market with an extension, said Dominik Winnicki, a credit strategist at Barclays.

“The lack of cushion of a higher coupon that could offset the downside of increased duration could lead to a multiple-point price drop,” he said.

Buyers should also take a close look at the terms of their individual AT1 holdings given the lack of uniformity in structures. According to BNP Paribas data, 44% of European benchmark AT1s (in all currencies) cannot be called after the first call date before another five years have passed, but 13% are callable every quarter. Another 9% are callable at any time.

Bonds with infrequent calls can appear more attractive for investors since they give the bank less flexibility, reducing the chance of an unwelcome surprise.

“It gives us a little bit more confidence that at that point in time they’re going to take it out,” said AllianceBernstein’s Hussey. (Reporting by Alice Gledhill, editing by Alex Chambers, Julian Baker)

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