Credit Research
AFreshApproachtoAnalyzingBankCapitalBonds
9 mins
The volatility of 2022 taught investors an expensive lesson that, to certain bank issuers and regulators, the economics of voluntary bond redemptions outweigh the reputational cost of not calling bank capital securities.
Last year’s jump in interest rates and widening in credit spreads hit callable bank securities particularly hard as many issuers abandoned the long-standing convention of calling capital securities at the first call date. These decisions upended market precedent and valuation considerations, leading us to the following adjustment for analyzing these securities. Bondholders should no longer extrapolate an issuer’s long-term track record of calling bonds; each issue should be evaluated on a case-by-case basis with the assumption that many of these bonds should be priced to maturity in accordance with the contractual agreement.
As we indicate below, pricing to the call or the maturity date is critical to views on valuation and the potential opportunities for investors (see the accompanying Appendix for further information).
A Fraught Decision
As banks encountered higher borrowing costs last year, those that issued callable bonds faced a decision on whether they should call the bonds at the first call-option date. By doing so, the banks would have increased their cost of capital if they refinanced during the period of rising interest rates and widening credit spreads. Conversely, extending a callable bond, especially one with a low coupon reset spread at the call date, made economic sense for many banks, even if it defied bondholders’ expectations.
Given this decision, in 2022, many issuers extended tier 1 and tier 2 (T1 and T2) securities in cases where coupons on the latter reset to yields lower than the cost of issuing a new senior bond. As a result of the extensions globally and in anticipation of similar outcomes, credit spreads on callable T2 bonds widened notably in late 2022. The widening in Australian, Scandinavian, and Asian callables (observed in Figure 1) stand in contrast to the performance of the bullet (non-call) structures from the euro area and the UK (green line, Figure 1).
Furthermore, investors weren’t the only entities increasing their scrutiny of bank capital securities at the time. Even in cases where banks wanted to maintain their option to call a bond in order to preserve their market reputation, regulators voiced hesitation to approve the request as they deemed the calls to be “uneconomic.” This hesitation reflected regulators’ preference to preserve bank capital by guiding banks to favor depositors and taxpayers over investors. For example, a letter by the Australian regulator on the matter (indicated by the vertical dashed line in Figure 1) reminded investors that calls must be approved by regulators; decisions around calls are not solely up to issuers.
Figure 1
The Varied Spread Performance of Callable T2 bonds by Region (bps)
PGIM Fixed Income, Bloomberg. This chart shows the EUR z-spreads of callable tier 2 bonds from four country / region blocks of issuance in different regulatory regimes. The selection of callables in each country or region block is made by PGIM Fixed Income and is based on issuances of 10-year final maturity / 5 year first call date, issued with historically low spreads for the reset after first call dates (<200 bps) issued during 2018, 2019, pre-pandemic 2020 and late 2021, then the average spreads being weighted by the amounts in issue. The contrast of bullets chosen are those with bullet three-year maturity in the same year with issuance spreads <300bp; these are mostly from euro area issuers, and the weighted average spread is calculated in the same way.
Allocation Implications
As we assess these bonds on a case-by-case basis, regional considerations also come into play as part of a comprehensive analysis, particularly when it comes to valuations. Indeed, we estimate that pricing tier 1 and 2 bonds to maturity could add an additional 50-150 bps in spread, depending on the bank and jurisdiction.
While the issue of callability remains a source of uncertainty in Europe, many banks still prioritize access to a large institutional investor base that values predictable behavior on behalf of issuers. As a result, we think big, mainstream banks in the Nordics, UK, and France will continue to call securities where expected, thus the market may be overpricing the extension risk on these bonds, potentially leading to attractive opportunities for investors. Meanwhile, European regulators remain attuned to the additional costs to issuers that are not able or willing to keep to the call convention.
In emerging markets, we are focusing on countries with stable macroeconomic conditions, strong regulatory capital rules, and clear visibility into banks’ asset quality. We also prefer to invest in banks with a greater sensitivity to their reputation and their long-term ability to access the capital markets. With that background, we remain underweight bank capital in Turkey and Argentina, while remaining highly selective in Brazil and Colombia where some issuers have opted not to call their Basel III issues on the call dates while others continue to pledge to call their bonds.
Conditions in Colombia provide a practical example of the variability of call options. Certain banks that were tier 2 capital constrained could not call the bonds last year without issuing a new tier 2 bond at a significantly higher spread and yield. The low coupon reset spread made the economics of the extension more compelling for these issuers, and they opted to disappoint the market, risking an investor backlash, by not calling their bonds.
Furthermore, the selloff in late 2022, as observed in Figure 1, created opportunities in certain pockets of EM bank capital, including Mexican tier 1 and 2 capital, Indian tier 1, Israeli tier 2, and Thai tier 2 bonds.
Conclusion
Following the turbulence of 2022, our revised approach to bank capital securities provides a tangible adjustment with notable investment implications. When looking ahead, we expect that yields and coupon reset spreads on newly issued TLAC bonds of all seniorities will be higher in the coming years as they should be priced on a case-by-case basis as opposed to the preconceived notion that they will be called.
As banks look to raise additional capital in an environment of relatively tighter spreads and lower interest rates, they may attempt to price deals to the call date. However, based on our estimates of the additional spread needed to compensate for the extension risk, investors should remain keenly aware of the new approach required to navigate the global market of bank capital securities.
Appendix
The following explains the history and regulatory mechanics behind the bank capital securities.
How Did we Get Here?
Ever since the Global Financial Crisis exposed banks’ balance sheet vulnerabilities, regulators worldwide have been enforcing various rules to ensure that shareholders and creditors – rather than taxpayers – will provide the capital to resolve the next banking crisis through principal and interest haircuts. As some investors began to resist the loss of protection and increased risks stemming from these new regulations, callable bond issuance began to pick up pace among banks.
Callable bonds limit the regulatory designation of the raised Tier 1 capital as final or perpetual legal maturity, a feature first introduced during Basel I in the 1980s. Before the Crisis, Basel I and II generation capital securities were sold with the explicit assurances that the effective maturity of these debts would be the first call date, hence reducing uncertainties for creditors on how to exit their investments. Also, creditors were somewhat protected under prior Basel eras as most Tier 1 and Tier 2 securities included coupon step-up provisions that are designed to incentivize banks to call bonds.
Fast forward to the post-crisis era of Basel III regulations and their focus on total loss-absorbing capital (TLAC) as a way to “bail in” banks that are too big to fail. TLAC requires banks to have financial instruments available during resolution to absorb losses and enable banks to be recapitalized during the resolution process, and it has even extended to senior securities in several countries. Just like their predecessors, Basel III-compliant and TLAC bonds also have the call feature. However, the coupon step-ups that were commonplace in previous Basel generations have largely been discarded. The regulatory rationale is to protect taxpayers when banks experience solvency or liquidity stress, as banks could simply extend Basel III notes rather than refinance them at higher rates, forcing bondholders to bail in the banks.
Despite the extension risk inherent in Basel III bonds, they were sold to investors in a similar context as the old Basel debt, when healthy banks would call the debt on the first call date despite the relatively low coupon reset spreads for issuers. In short, while the prospectus documents of TLAC issuances stated clearly that these bonds were callable, investors were led to assume otherwise. For many years under low interest rates, this verbal promise was essentially untested because banks could easily call bonds and refinance at similar, if not lower, interest rates.
Extension Risks Inherent in TLAC Bonds
To examine TLAC bonds’ extension risks, it is important to understand the nuances between the three types of TLAC bonds: senior subordinated (“TLAC senior”), Tier 2 and Tier 1 (“legacy”), and Basel III compliant Tier 2 and Additional Tier 1 / AT1.
To meet TLAC requirements, senior subordinated bank bonds or “TLAC senior” bonds are the instruments that would be explicitly next in line to absorb major losses in a resolution where the bank largely continues as a going concern and does not face liquidation or bankruptcy. They rank senior to the Tier 1 and Tier 2 instruments that bear losses first. Depending on the legal structure of the regulated banking groups, these TLAC senior bonds are issued as either holding company (HoldCo) senior unsecured or as Senior Non-Preferred (SNP) issued from the top regulated entity of the structure (which also happens to be a bank operating company). The HoldCo structure is prevalent in the U.S., Japan, the U.K., Switzerland, Ireland, and Benelux, while the SNP-issuing top operating company structure is prevalent in Europe, Australia, and Canada. In general, the senior unsecured bonds designed to meet TLAC (and in Europe, MREL) lose their validity for the calculation of the capital ratio a year before maturity. Hence, their issuance has increasingly had a feature of a one-year early redemption or a call option for the issuer versus the final maturity.
Tier 2 notes under Basel III count toward TLAC in all countries that have TLAC regulatory requirements and solvency capital requirements. Typically, if the bonds are not called, banks lose 20% of subordinated capital treatment per year over the final five-year period until maturity. Consequently, the first call option is typically five years before the legal maturity. Most of the callable Tier 2 notes issued after 2013 to comply with Basel III have a single call option at that date and the coupon is reset at the same spread over a five-year government or swap rate as the coupon had at issuance, on the basis of assumed redemption at first call date (fixed-to-fixed).
Increasingly, however, the issuance of either a reset to a floating rate at first call (fixed-to-float) or even a floating rate all the way to final maturity (float-to-float) has increased. As there is no longer a coupon reset on the credit spread that is considered a step-up, these subordinated bonds can reset at quite low levels compared to today’s elevated interest rates and spreads. Banks are left with paper that regulators treat as senior in the capital ratio calculations, but if the new coupon is reset at a level in line with TLAC senior or even other senior unsecured debt, banks should be indifferent to this risk if they prioritize the economic rationale.
Additional Tier 1 and pre-Basel III “legacy” Tier 1 securities also count toward TLAC in all applicable countries and are considered the highest risk for investors for several reasons. First, they have no maturity as they are perpetual bonds. They are also subordinated to Tier 2 bonds in the capital structure, though they are considered senior to common equity. This matters in the event of a bank insolvency, resolution, or liquidation. Finally, if Tier 1 bonds are not called, they do not lose the corresponding capital treatment so there is even less incentive to call these bonds in a rising rate environment. They typically have calls every six to twelve months, however, so they are likely to be called when rates decline. The extension risk and multiple call dates make the pricing of these securities especially tricky for investors.
1 Regulators’ heightened scrutiny of call options may apply more closely to institutions that need to build their required stack of total loss-absorbing capital (TLAC). The warning by the Australian regulator in late 2022 initially stymied issuance, but indications are that the official guideline may be more nuanced. As a result, large Australian issuers have recently proceeded with their calls. Ultimately, in most regulatory regimes, banks get annual ex-ante permission from regulators to call bonds if they have adequate headroom over the required TLAC levels.
2 If banks regulatory solvency metrics are met, European issuers also have the means to “pre-replace” securities, regardless of spread.
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