Legacy Tier 1 in cross-hairs as StanChart breaks with convention

* Investors caught off guard by StanChart (HKSE: 2888-OL.HK - news) no-call

* Market reassesses risk in legacy Tier 1 debt

* CMZ's Tier 1 falls after CFO comments

By Will Caiger-Smith and Alice Gledhill

LONDON, Nov 4 (IFR) - Holders of old style hybrid Tier 1 bank debt were left nursing hefty losses this week after Standard Chartered (BSE: 580001.BO - news) said it would not redeem a US$750m legacy Tier 1 bond next January, while confusion reigned as to whether Commerzbank (Xetra: CBK100 - news) would take a similar decision relating to one of its bonds.

StanChart's perpetual preferred instrument, which currently pays a coupon of 6.409%, tumbled 14 points this week after the bank said on Tuesday that it would not exercise a call option embedded in the notes.

A 416m 6.352% Commerzbank bond callable in June 2017 dropped almost eight points on Friday after the bank's CFO told reporters that he did not see why he should buy them back.

In order to maintain good relations with bondholders, issuers have, by-and-large, adhered to market conventions dictating that they should call transactions at the first opportunity, even when it is uneconomical for them to do so.

StanChart's decision flew against that "gentlemen's agreement", and investors are now set to be paid just 151bp over Libor, equivalent to around 2.39%, after the January call date.

The bonds are not eligible for early redemption again until 2027.

"We will make call judgments based on all the circumstances at the relevant time," Christopher Daniels, head of capital management at StanChart, told IFR.

"Economics will be one factor, but not necessarily the only factor. These are good Tier 1 capital for the next three years. On that basis, there is reason to not call them."

Legacy hybrid Tier 1 instruments without a step-up are treated more favourably under Basel's grandfathering rules and StanChart said it expects the securities to count as Additional Tier 1 capital until 2021, and as Tier 2 thereafter.

"The good old days of call options in Europe being a wink and a nod is probably a thing of the past," said a FIG DCM banker.

"It is hard for a bank to go to its regulator and convince them of the benefit of making a non-economic call."

Another said he was surprised by the market reaction.

"I can see why they didn't call them from an economic and capital perspective," he said. "These are non-step securities; it's good quality capital. Having said that, they may have underestimated the impact of their decision."

PRICING BENEFIT

The decision on whether or not to call such bonds lies with an issuer and the economics alone should have led bondholders to believe the call would not be exercised, said bankers.

"There was no rational reason for calling them, unless they just wanted to keep investors happy," said another DCM (BSE: 502820.BO - news) banker.

"The downside in this trade was a lot more than the upside."

StanChart paid 7.5% for its last US dollar AT1 deal, a perpetual non-call 5.5-year sold in August, and 4.3% for a US dollar Tier 2 deal, a 10.5-year bond sold later that month.

It raised 10-year senior debt in US dollars in April, paying 4.05%.

Even (Taiwan OTC: 6436.TWO - news) though it is less risky, that senior bond still pays roughly 166bp more than the coupon StanChart will pay on the US$750m perpetual securities for the next 10 years.

PAINFUL LESSON

The decision not to call was a bitter pill to swallow for many investors.

"We would strongly question whether from an investor-relations standpoint the capital treatment is worth it to let real money investors lose as much as they did today," said Cindy Harlow, a bank analyst at Imperial Capital, on Tuesday.

Much of the pain was felt in Asia, where private-bank investors hold many of the notes.

"Asian investors view the StanChart name as having a touch of magic," said the FIG DCM banker.

"They see a 6% coupon and the StanChart name and the January 2017 call and say 'what could go wrong?'. Today, they found out."

OFF-GUARD

StanChart's decision not to call started a sell-off in similarly structured bonds issued by European banks as investors look to avoid being caught off-guard again.

Commerzbank suffered some of the biggest losses after the bank's CFO told journalists during a call on Friday that, from today's perspective, he did not know why he should buy back a euro legacy Tier 1 bond.

However, according to an investor relations official at Commerzbank, there could have been confusion as the CFO was asked whether he would "buy back the bonds" instead of whether he would call them. The IR official was unable to clarify precisely what the CFO meant, or whether the bonds would indeed be called.

The securities do not have step-up language and the market's reaction pointed to investors fearing that Commerzbank would follow in StanChart's footsteps.

A Royal Bank of Scotland US dollar 7.64% perp callable in 2017 fell more than five points to 91.7 on Tuesday. It had recovered to around 95.8 by Thursday.

BNP Paribas (LSE: 0HB5.L - news) analysts reckoned it was among the legacy Tier 1 bonds most vulnerable to extension.

A Credit Agricole US dollar 6.637% bond callable in 2017 had fallen more than three points by Thursday, to 96.5 according to Eikon.

"A lot of AT1 bonds have reset spreads that are tighter than current trading spreads, so if banks were to replace them today, they'd have to pay more," said Dominik Winnicki, a credit strategist at Barclays (LSE: BARC.L - news) .

"There is definitely some extension risk priced into AT1s, but this event could push it a bit further."

CONFUSION

However, working out whether bonds are going to be called is far from easy.

Issuers need to carefully weigh up the economic benefit of leaving such debt outstanding versus the possibility that the debt would not be eligible for TLAC and MREL, banks' cushions of loss-absorbing debt.

Banks also run the risk of damaging their relationship with investors if they choose not to call.

Investors holding StanChart's bonds, for example, said they were surprised by the bank's statement that it expected the bonds to count towards Tier 2 after 2021.

In the bank's regulatory capital disclosure in December it listed the bonds as AT1 capital until 2021 and then simply as "ineligible" thereafter, with no reference to Tier 2.

Investors argued that the wording suggested the bonds would not count as any form of capital - Tier 2 or otherwise - after 2021, making them more likely to be called.

But while sellside participants said they were sympathetic to the difficulties caused by such ambiguities, they also said investors had to be realistic and do their own due diligence.

"These capital rules are moving around so much that to take anything as gospel is tough," said the FIG DCM banker.

"You're supposed to do your own homework when you own a perp."

(Reporting by Will Caiger-Smith, Alice Gledhill, editing by Shankar Ramakrishnan, Helene Durand, Matthew Davies)