GAM’s Mivelaz: Regulation drives bond opportunities in Europe’s banks

Gregoire Mivelaz

Since the global financial crisis, which required hundreds of billions of dollars in state funds to bail out banks, the regulators have been hard at work to prevent history from repeating itself. While the basic principle for how to strengthen the banks – require them to hold more capital – is an easy one, its implementation has been far more complex.

The regulators and banks were forced to act fast. The Basel Committee on Banking Supervision had taken five years to come up with the set of capital adequacy rules known as Basel II. But when the crisis hit, it published a revamped framework (Basel III) just two years after the collapse of Lehman Brothers.

Basel III intensified the focus on the highest quality of capital, common equity, rendering billions of securities that were issued previously as a substitute for equity obsolete. It also requires banks to fulfill new requirements and issue new types of securities to make sure they can absorb potential future losses.

Banks, under pressure also from their shareholders, have been deleveraging and raising capital levels to satisfy the new standards. On a pan-European basis, core capital ratios increased by almost 50 per cent since 2008 to 13.1 per cent of risk-weighted assets in June 2016. All of this has been good news for investors of subordinated debt as stronger bank balance sheets reduce the risk of default.

However, not all subordinated debt is created equal, so bond selection matters. For example, we favour so-called legacy Tier 1 securities. These securities were issued under Basel II for regulatory capital purposes as a cheaper form of equity. Contractual conditions set in their prospectus were very loose at the time of issuance, with investor-friendly clauses. In addition, they did not have any automatic conversion or permanent write-down features, such as the new types of securities issued under Basel III.

Banks were given a period of 10 years, the so-called grandfathering period, to replace legacy Tier 1 securities – either with contingent capital securities (so-called Additional Tier 1 or AT1 notes) or common equity.

For the issuers, legacy Tier 1 securities are a very inefficient form of capital as over time they lose their eligibility as regulatory capital. But for investors, they are still a once-in-a-lifetime buying opportunity. There is no new supply and no extension risk, while the paper benefits from continuous improvements in the underlying credit story and an extra yield over government bonds of as much as five times what one would otherwise get for a senior unsecured bond of the same issuer.

The amount of legacy Tier 1 is obviously diminishing over time, but with about €150bn of outstanding securities it is still bigger than, for example, the AT1 notes market with a current size of about €110bn.

We also see attractive investment opportunities among some of the newer securities, thanks to the fact that even the new requirements and guidelines for banks under Basel III are still changing. AT1 instruments all contain contractual provisions that are triggered when a bank’s capital ratio falls to a pre-defined level. They differ by whether they are converted into ordinary shares or are written down, and also at what capital level the trigger is set.

We favour low-trigger securities with equity conversion. Equity conversion preserves equity subordination. Low-trigger AT1, especially those with a trigger set at 5.125 per cent seem incompatible with what regulators actually had in mind when they were created.

Because for previous stress tests a minimum common equity requirement of 5.5 per cent was applied, it means we have outstanding capital securities where the trigger level is actually lower than the implicit point of non-viability. Hence, we see a high probability that these securities will be grandfathered going forward, removing the extension risk.

To sum up, EU banks have experienced eight years of continuous regulatory pressure and changes. The quality and quantity of regulatory capital has significantly increased, making European banks strong again. Equally important is that mechanisms as well as backstops have been put in place to prevent contagion and systemic risk. The regulatory journey is a complex and evolving one, but it creates unique investment opportunities if it is well understood.

Grégoire Mivelaz is a fixed income manager at Atlanticomnium, which manages several GAM credit strategies.