Cosseted bank bondholders need to feel more pain

LONDON, July 4 (Reuters Breakingviews) – Bank bondholders need to feel more pain. Credit Suisse’s (CSGN) haste this month to repay a hybrid bond at the first opportunity looks odd given the elevated cost of replacing it. There is a rational explanation. The problem is it highlights broader flaws in the USD 212 billion market for bank capital securities.

June 16 was a good day for holders of the Swiss lender’s USD 1.5 billion hybrid. The so-called Additional Tier 1 bond had been trading at 95% of face value, reflecting the risk of the bank leaving it outstanding rather than exercising its right to pay it back early. When the bank chose instead to redeem, the bond’s price recovered. Credit Suisse fared less well. To maintain its capital levels, the struggling lender had to issue a new bond with a 9.75% coupon, some 115 basis points above the likely interest rate on the old one, implying an extra cost of some USD 17 million a year.

After the 2008 crisis, regulators tried to make hybrids, which count towards lenders’ Tier 1 capital ratios, truly equity-like. That meant giving them triggers that convert into shares and coupons that can be cancelled. Structures to incentivize early repayment, such as coupons that crank up when bonds aren’t redeemed early, were also banned. Yet hybrids still contain “call options” on early repayment, and regulators give some leeway on their use. While a handful of lenders like Banco Santander (SAN) have taken a hard-nosed approach, most European banks still pay off Tier 1 bonds on the call date even if it costs more to replace them.

The obvious advantage is cheaper funding. Yet the presumption of redemption also creates risks: troubled banks may end up paying higher interest rates to replace retiring debt, or markets might get spooked when banks choose not to redeem. Credit Suisse also had some unique motives, such as the desire to be rid of liabilities with now-redundant Libor-based coupons.

The coming months may stiffen lenders’ resolve. Recession fears mean the cost of issuing hybrids is rising, giving other banks like UniCredit (CRDI) the dilemma of extending debt or replacing it at higher cost, CreditSights reckons.

Regulators could clear up the uncertainty by insisting, for example, that banks only redeem debt if they can refinance at cheaper rates. They also need to look at hybrids’ other equity-like features, to ensure for example that bonds can defer coupons or be turned into equity before the bank actually goes bust. A rethink that makes life tougher for bondholders is needed.

CONTEXT NEWS

Credit Suisse said on June 16 that it planned to redeem a USD 1.5 billion Additional Tier 1 bond. The security carried a 7.125% coupon, which would have reset to around 8.6% after its call date in July, according to CreditSights. The redeemed bond was replaced with a new issue with a 9.75% yield.

Banks have issued 202 billion euros of Additional Tier 1 securities, according to CreditSights data. The securities count towards lenders’ Tier 1 ratios due to their loss-absorbing features. These include the right to convert them into equity or to defer coupons, as well as their lower-ranking status and potentially permanent maturity.

(By Neil Unmack; Editing by Ed Cropley and Oliver Taslic)