European Banks Dump Massive Amounts of Subordinated Debt on Investors ; Big rise in subordinated debt issuance by EU banks

December 17, 2013 6:34 pm

European Banks Dump Massive Amounts of Subordinated Debt on Investors ; Big rise in subordinated debt issuance by EU banks

By Christopher Thompson

Europe’s banks are preparing for the possibility their creditors could face losses in the event of bank failure by issuing bumper amounts of subordinated bonds designed to absorb losses.Banks have taken advantage of yield-chasing investors to issue $90.7bn of subordinated debt for the year to date, a 41 per cent increase compared to the same period in 2012. It is the highest such volume since the $122.4bn seen in 2008 according to Dealogic, the data provider.

The figures follow a deal agreed by European regulators earlier this month that will bring in so-called bail-in rules for senior bondholders from 2016, two years earlier than envisaged by finance ministers in their common position agreed in June.

Subordinated bonds are ranked behind senior bonds in a bank’s credit hierarchy but pay out more in interest as a result. While senior bonds can suffer losses if a bank defaults, issuing more subordinated debt, separated into tier one and tier two categories, has the knock-on effect of lowering the cost of senior debt by providing a bigger cushion for lenders.

Khalid Krim, head of capital solutions at Morgan Stanley, expects the subordinated debt splurge to continue next year as banks seek to improve their leverage ratios – which calculates tier one capital to total assets – and protect senior bond holders.

“We expect at least €35bn in tier two issuance coming next year and about €45bn-€50bn of tier one issuance as banks start to replace their legacy subordinated bonds,” he said. “By issuing more tier one debt banks can improve their leverage ratios while tier two is about buffering senior investors from bail-in.”

Incoming European regulations require banks to hold greater amounts of capital against loans and to issue bonds that can sustain losses to avoid taxpayers being left on the hook if a bank collapses.

As a result, banks are also expected to issue record amounts of loss-absorbing contingent convertible – or “coco” – bonds next year, which can either convert to equity or wipe out investors entirely if a bank’s capital ratio falls below a pre-agreed level.

“Investors are keeping an eye on how Europe’s bail in regime gets implemented and how banks organise their capital structures accordingly,” said Peter Jurdjevic, head of balance sheet solutions at Barclays. “We will see more issuance of Tier 1 and other subordinated debt next year.”

Most subordinated European issuance has come from core banks – or those perceived by investors as strong enough to withstand economic shocks – although there has recently been an uptick in issuance from those located in peripheral countries as well.

The jump in subordinated issuance flies in the face of wider deleveraging among Europe’s banks, in which senior unsecured bond issuance has fallen to record low levels as banks retrench their operations.

As investor confidence in the eurozone has returned this year the cost of insuring banks’ subordinated debt – a key measure of funding costs – has decreased by more than half: it costs €139,000 per year to protect €10m in subordinated debt, down from €320,000 in March, according to the iTraxx Europe Subordinated Financials index.