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Watershed looms for CoCo market as Banco Popular bonds approach trigger

Investors fear that troubled Spanish lender Banco Popular Español SA could be about to test one of the pillars of post-crisis financial reform, by breaching capital levels that trigger the conversion of a bank's Additional Tier 1 bonds into equity for the first time since the asset class's invention.

Additional Tier 1 capital, in the form of contingent convertible, or "CoCo", bonds, is designed to convert into equity or be written off if a bank's capital levels breach predesignated trigger points. Regulators insisted that banks hold them to avoid a repeat of the serial taxpayer bailouts that followed the 2008 financial crisis, and, while they have attracted eager purchases from investors seeking higher returns than those available from ordinary bank debt, so far market appetite has not been tested by any actual bail-in, or even by the suspension of coupon payments they also allow for.

"We are reaching the point of maximum uncertainty with Banco Popular's CoCos," said John Raymond, a banks analyst with CreditSights in London. "There is a high possibility they will get triggered even if the bank is acquired by Santander," he added.

Banco Santander SA, the largest Spanish bank, remains the last investor still in play for Popular after a series of previous candidates pulled out. The acquirer will not be obligated to convert the bonds in question but it would make little financial sense for it to keep them on as part of a deal, Raymond said. He estimated that Popular is short around €5 billion in capital, with €3 billion needed to make minimum standards.

"Santander will want to make sure that they are taking over a clean bank, therefore I would not be surprised if Santander would try to use the subordinated packet of Banco Popular, not only the AT1 but also the scraps of Tier 2," Filippo Alloatti, senior credit analyst at Hermes Investment Management, said in an interview. "I think it will be a milestone for the AT1 market because […] no single bank has so far triggered an AT1," Alloatti said.

Having failed to find willing buyers so far, Popular's management is now considering requesting emergency liquidity assistance from the European Central Bank, Bloomberg News reported June 6.

The chances that Popular's capital cushion will shrink enough to trigger the conversion of the AT1 bonds are increasing, CreditSights warned in a report. This could come as a result of increased provisioning against bad loans before a sale, a voluntary wind down of some of the bank's debt known as liquidity management exercise, or through regulator-driven resolution proceedings, it said.

Popular has €750 million in AT1 bonds that will be converted into equity if its CET1 ratio reaches 7% and another €500 million that will be triggered by a 5.125% CET1 ratio. Its fully loaded common equity Tier 1 ratio was 7.33% at the end of the first quarter.

The two securities were trading at 55 cents on the euro and 61 cents on the euro, respectively, as of June 6, according to S&P Global Market Intelligence data.

The broader AT1 market has already seen some weakness as a result of investor concerns related to Banco Popular's troubled situation, but, the disruption is nothing compared to what could happen if the first AT1 were actually converted, according to Rabobank credit analyst Claire McNicol. "This would be the first time the market would see an AT1 conversion in action and I believe would trigger many market participants to reassess the risk," she said.

In an initial "knee jerk reaction" there would be a sell-off across the asset class as a whole, according to McNicol. "We would then see many curves coming back in as the risks for very well capitalized banks were reflected. Peripheral and weaker names would no doubt remain wide however," she added.

The whole AT1 market might suffer repricing and volatility as a result, Raymond said, but he didn't expect issuance to slow down because of Popular's woes.

"[Popular's conversion] wouldn't be helpful for the asset class," he said. "The first conversion will affect pricing in the short term and will cause some volatility … The market will recover eventually."

Spanish peer Caixabank issued €1 billion in CoCos on June 2. Europe's banks have issued about €100 billion of the bonds to date, according to the Financial Times.

Banco Popular declined to comment for this article.