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Credit in the crosshairs as European banks face refinancing CoCos in 2018

European banks' riskiest form of debt has given investors a stellar year of returns, but several pioneering Additional Tier 1 bonds are set to be refinanced in 2018, and there are concerns that weaker banks could be hurt by a credit correction that many argue is increasingly likely.

Additional Tier 1, or AT1, bonds – so-called contingent convertible or "CoCo" debt that is written off if a bank's capital falls below a predetermined trigger level – has been one of the stand-out asset classes in global fixed income in 2017, yielding excess returns just short of 16% year-to-date, according to CreditSights.

Nordic lender Nordea Bank AB (publ) set an all-time record last month when it printed a €750 million perpetual non-call seven-year deal with a coupon of just 3.5%, while Spain's Banco de Sabadell tapped the same market for €400 million in November and Portugal's B1/BB-/BB- rated Millennium BCP printed a €300 million Tier 2 capital bond.

Even in the context of lofty valuations in markets the world over, the risk appetite on display from bank investors has raised eyebrows, and euro-denominated AT1s have slipped in recent weeks, generally trading between 80% and 95% of their 12-month highs, CreditSights said.

"AT1 has been one of the pockets people have turned to for yield, so if you're saying valuations across the market are out of whack then there is perhaps an argument to say certain AT1 bonds will be some of the most overvalued," said one senior credit analyst at a London-based asset manager.

"We are seeing a shift towards quality names as year-end approaches, which suggests there is some more focus on the downside."

Tough timing

Credit market exuberance, rational or otherwise, has come at a tricky time for European banks, whose shares are down 3.5% from their peak in May despite a booming European economy, while their U.S. rivals have surged by some 17%.

Their relative underperformance has largely been down to two regulatory issues, one being the now-completed 'Basel IV' rules limiting their use of internal models to lower their capital requirements, and the other being the European Central Bank's plan to tackle nonperforming loans, or NPLs, that have dogged the continent's banking sector since the 2007 to 2008 financial crisis.

The 72.5% capital output floor announced by the Basel Committee on Banking Supervision on Dec. 7 was not as high as U.S. regulators had been pushing for and has given bank investors more clarity, but it still leaves Europe's lenders with a collective €40 billion capital shortfall, and they insist that it gives their Wall Street rivals an unfair advantage.

On Europe's near €900 billion stock of NPLs, the ECB in October unveiled a stricter set of rules, due to take effect from January, forcing banks to set aside more provisions against losses on soured loans.

The central bank has since said it may delay their introduction after EU lawmakers argued that effectively increasing banks' capital requirements was beyond its mandate, but concerns remain that a more demanding reduction of NPLs in countries like Italy could lead to fire sales and damage bank balance sheets.

Priced for perfection

The AT1 market faces a pivotal year in 2018. While AT1s are perpetual, issuers have the option to "call" them, or redeem them, after five years – a period which is set to come due for the very first bonds of the type issued in 2013. While bond investors generally expect banks to exercise call options, lenders will have to consider the relative costs of refinancing the debt or of holding onto it, as coupons will reset higher.

Yields on AT1 bonds have generally trended downward since Spain's Banco Bilbao Vizcaya Argentaria SA issued the first such deal with a 9% coupon in 2013, as European banks cleaned up their balance sheets and bolstered their capital defenses, giving bondholders more confidence that they would not be wiped out. BBVA's AT1 would reset to a coupon of 826.2 basis points over five-year U.S. swaps if not called.

The asset class has also overcome major challenges in the last two years, most notably a sharp sell-off in early 2016 triggered by concerns over Deutsche Bank AG's ability to pay its coupons, and then the failure of Banco Popular Español earlier this year, where losses were imposed on AT1 bondholders for the first time. In the latter case, to the surprise of some, AT1 investors were wiped out after the Spanish bank ran into liquidity problems, even though its capital levels remained above trigger levels.

"We have seen a maturing of the market," said one head of capital solutions at a major investment bank in London. "There was contagion following the BPE event, as investors have been educated and are comfortable with the risks."

However, the product has benefited from being one of the highest-yielding available in an era when central banks have crushed returns in lower-risk markets, and there are much safer assets than AT1 now being called overvalued.

Morgan Stanley's head of credit, Srikanth Sankaran, told clients in his 2018 outlook that global credit markets were "priced for perfection" and recommended buying higher-quality AT1s as part of a defensive strategy.

"Valuations are pricing in a very benign macro environment, with spread/leverage across regions at or near historical tights," he said. "In Europe, fundamentals look solid, but spreads are clearly pricing in this backdrop and yields are even more challenging."

Is small safe?

Sankaran believes fresh concerns over smaller Italian banks could be one of the idiosyncratic risks the market is vulnerable to in 2018.

"Sensitivity to these risks is likely to be higher later in the year when the market focuses more on the central bank balance sheet unwind," he said.

Small and medium-sized banks accounted for 37% of the $21 billion raised via AT1 in the third quarter and some 79% of the transactions, according to Fitch, and the rating agency expects issuance in 2018 to increasingly come from banks that have so far been less present in the market.

"There is a lot riding on this so-called Goldilocks scenario continuing," said the manager of an alternative credit fund based in London.

"When you look at the Nordea trade, I thought that was people saying, 'I want the yield but I want it from a gold-plated name if things are looking toppy.'

"I don’t know if you can say AT1 valuations are more inflated than anything else, but a big correction in credit would clearly be felt there and that would put pressure on smaller banks looking to enter the AT1 market or raise more capital."