Banks tap into promising market for "top-up" capital bonds

By Steve Slater and Aimee Donnellan

LONDON, Sept 6 (Reuters/IFR) - European banks are stepping up plans to raise money via bonds that can top up their capital, following a green light from regulators, potentially opening up a market worth up to 240 billion euros ($317 billion).

The bonds, known as hybrids, have equity-like features but are cheaper than equity and could help banks meet tough new rules to prevent a repeat of the 2007-2009 financial crisis when taxpayers bore the brunt of bank bailouts.

Regulators in Britain, France, Spain and Italy have agreed banks can count hybrid bonds as Tier one capital - a key measure of financial health. They can also be used to help lift banks' leverage ratio, where regulators are setting strict rules to cap risk.

France's Societe Generale (Paris: FR0000130809 - news) sold a so-called Additional Tier one (AT1) hybrid bond last week and bankers said as many as 10 more deals could follow in the coming months, ending a drought in the hybrid Tier 1 market.

Bankers were just as optimistic a couple of years ago about prospects for bonds known as "CoCos" or contingent convertibles that also had potential to meet regulators' capital demands because they convert to equity in times of stress.

But CoCos did not take off in the way many bankers had predicted, as mixed messages from regulators and changes in capital demands deterred all but a few banks from selling them.

Bankers estimate that lenders have sold only about 25 billion euros of CoCos since the financial crisis, about a tenth of the forecast size of the market for top-up hybrids.

AT1 hybrids may have more success now regulators are backing them and given signs of investor appetite. The bonds can be structured as CoCos or have so-called write-down/write-up or wipe-out features once trigger levels are breached. This means investors potentially could lose some or all of their money.

Societe Generale's bond had a "temporary write-down" feature where the bonds would temporarily be wiped out if the bank's core capital ratio fell below 5.125 percent.

"Societe Generale's temporary write-down trade offered a perfect template for other banks to follow," Gerald Podobnik, head of capital solutions at Deutsche Bank (LSE: 0H7D.L - news) , said.

"There are good signs out of Spain, France, Italy and the UK in terms of the tax treatment of these instruments, which will put the impetus on other countries to provide clarity as soon as possible."

Interest payments on bonds can be tax deductible, adding to their attractions as a lower-cost option than equity.

Most banks are likely to have to tempt investors with 6-8 percent in annual interest on the bonds, an attractive option in a world of near zero interest rates. But this is still cheaper than issuing equity, which typically costs around 10-12 percent.

"We'll definitely look at it ... there's a price for everything. If we are compensated fairly for where we are in the capital structure, and it's the right bank, we'll do it," said Matt Eagan, co-manager of the $22 billion Loomis Sayles Bond Fund.

But banks in Europe's weak economies may have to pay nearer 10 percent or more, making it less cost-effective.

NECESSARY BUFFER

Regulators have said banks can hold AT1 bonds equivalent to 1.5 percent of risk-weighted assets (RWAs). RWAs are assets, such as loans, adjusted for the likelihood of non-payment.

That would equate to 240 billion euros of these hybrids, based on European banks holding 16 trillion euros of RWAs, according to Deutsche Bank analysts.

"We would expect this to be issued over around five years, between 2014 and 2019, implying an annual run-rate reaching 45 billion euros of AT1 per annum," the analysts estimated.

But investors are also wary about the riskiness of the bonds, so the 240 billion euro forecast may be optimistic.

The most European banks have ever sold in hybrid Tier 1 bonds was $34 billion in 2007 and the only other year it topped $30 billion was in 2006, according to Thomson Reuters data.

Barclays (LSE: BARC.L - news) and Deutsche Bank have said they will issue those bonds and bankers say the likes of Danske Bank and at least five others are ready to pull the trigger. Emil Petrov, head of capital solutions at Nomura, said a number of European banks are in preparation mode.

Danske said it was considering its options for issuing AT1 bonds, which it said could occur before it repays state hybrid capital in April 2014.

Banks that have issued another class of hybrids known as Tier 2 in the last two years, including Barclays and Credit Suisse, have had strong demand, from European and U.S. institutional investors and Asian and private banking customers.

For its AT1 bonds, Societe Generale had more than three times the demand it needed for its $1.25 billion offer and Spain's BBVA (Madrid: BBVA.MC - news) had its order book covered six times for an $1.5 billion issue in April.

"The combination of the greater regulatory clarity and focus on the leverage ratio has got interest going and more people looking at it," one senior banker said.