LONDON (Reuters) - Banks are set to ramp up their sale of high-risk debt to investors desperate for new ways of bolstering their profits as rock-bottom interest rates hit their portfolios.
Demand for the riskiest — and often the most rewarding — form of bank capital debt, known as CoCo bonds, has risen sharply in recent months as the return on the bonds of Germany and other countries have dwindled to worse than nothing.
Nearly half of European corporate debt now carries negative yields, and with rates falling in the United States, demand for bank capital has increased as investors accept higher risk in exchange for some sort of return.
Now banks are preparing a raft of such bond sales as they look to boost their balance sheets ahead of schedule.
“Climb down the capital structure,” analysts at UBS said in a recent note titled ‘How to find yield in Europe’, though they recommend a slightly less risky form of bank capital referred to as Tier 2 subordinated debt.
But bankers are advising lenders to use this environment to refinance the most risky and expensive version of debt, known as continent convertible (CoCos) or Additional Tier 1 (AT1) bonds.
Swedbank, BBVA, Rabobank and ING have tested the market and found it receptive — demand for Swedbank’s CoCo bond was 14 times the $500 million size at one stage — and others are set to follow.
“We recommend that banks that have upcoming call dates on AT1 capital take advantage of the strong market,” said Kapil Damani, head of capital products at BNP Paribas.
Call dates refer to the point at which banks have the option of redeeming a CoCo bond; in most cases they do so at the first opportunity, though Santander recently became the first bank to break that norm.
“I know we’ve said this before and it didn’t prove to be the case, but this does feel like a once-in-a-lifetime opportunity to issue bank capital at these rates,” said one banker, who provides advisory services to financial institutions.
Several European banks such as Societe Generale, HSBC, BBVA and UBS are likely to redeem CoCo bonds when they become “callable” in 2020 and are ideal candidates, three bankers said.
BNP Paribas’s Damani added that banks are considered relatively safe investments in credit, after making extensive efforts to cut debt and improve their balance sheets following the 2008 financial crisis.
“So we expect AT1 to continue to perform relative to other high-beta assets,” he said. High-beta is a term used in the market to describe assets seen as riskier but potentially offering higher returns.
Around $21.4 billion equivalent of European CoCo debt are callable in 2020, according to BNP Paribas, which means that they probably need to be refinanced.
CoCo bonds were brought in after the 2008 financial crisis to ensure that bond investors as well as shareholders would bear losses if a bank ran into difficulty before any taxpayer cash was needed.
In 2017, Spain’s Banco Popular shocked its creditors by imposing losses on 1.25 billion euros of CoCo bonds.
Lenders such SNS Reaal in the Netherlands, Britain’s Cooperative Bank and Italy’s Monte dei Paschi di Siena have also imposed losses or conversion to equity on other types of bank capital debt.
But banks that come in now will find a much more benign market than last time round.
Markit’s iBoxx euro CoCo index is at a record high, while the average yield on euro subordinated bank bonds — which includes CoCo bonds — is near an all-time low at 0.88%.
As recently as the start of this year, that average yield was 2.46%, following December’s sharp sell-off in risk assets, and around 1.5% at the time of the Banco Popular CoCo bond writedown in June 2017.
“We generally think European banks are quite attractive and we see value in capital instruments as many of these names are extremely well-capitalized compared to the crisis years,” said Kaspar Hense, a portfolio manager at BlueBay Asset Management.
“Even in the event of a recession, we don’t expect too many losses to be triggered (on this debt). Of course, there are risks, which is why we focus on the national champions,” he said, a phrase that describes the biggest and most systematically important banks.
Graphic: European banks see cost of "junior" debt issues plunge, here
Reporting by Abhinav Ramnarayan, editing by Rachel Armstrong and Larry King