U.K.banks' funding costs have risen only modestly despite the country's shock voteto leave the EU, but their plans to sell billions of dollars of debt to meettoo-big-to-fail rules are overshadowed by Brexit's uncertain impact onfinancial markets and the economy.
andSantander UK Plc werequick to test bond markets following the June 23 referendum, despite falls ofas much as 30% in the country's bank stocks. Lloyds sold $1 billion of afive-year unsecured note at a spread of 210 basis points. The deal saw gooddemand, showing debt investors were looking more resilient than equity markets,Claire McNicol, a credit analyst at Rabobank, said in an interview. Santanderraised £500 million from a mortgage covered bond.
TheLloyds and Santander deals might be among the first of a rush of bond sales incoming months as banks seek to catch up with plans for meeting regulatory standardsfor bail-in-able debt, which were already disrupted by a February bond marketfreeze, McNicol noted, while adding that banks are stronger than a decade ago,after having raised more than £130 billion of capital since the globalfinancial crisis.
Price of uncertainty
Theprospect of Brexit will, however, push up British lenders' debt costs asuncertainty stretches through a two-year negotiation period with the EU thatwill begin after the U.K. government invokes a treaty article formallyinforming the bloc of its intention to leave, McNicol said.
Seniorunsecured bond spreads jumped 20 basis points from June 23 to 96 July 1, whilecovered bond spreads edged 4 points higher, according to the Bank of England.
Lookingahead, banks potentially face losing "passporting" rights allowingthem to market their services across EU borders. Meanwhile, lower officialinterest rates will drain margins and property fund redemptions have sparkedconcern of a spillover into house prices.
Allmajor U.K. banks' common equity Tier 1 ratios would fall close to the 7%threshold triggering conversion into equity or write-downs of Additional Tier 1bonds in the extreme, but not unlikely, case that residential house prices wereto fall by 35%, JPMorgan analysts led by Matthew Bailey wrote in a note. Thereis a much higher chance that banks' capital could be eroded sufficiently forinterest payments on AT1 bonds to be suspended unless they raise more equity,JPMorgan said. A serious risk of a missed coupon would drive up senior debtyield spreads by 100 to 200 basis points, it said.
Theyield on a Barclays contingent convertible bond, a proxy for U.K. bank fundingcosts, according to Wells Fargo, jumped to 12.1% June 27 from 8.51% onreferendum day, but this was below the 12.8% high reached in February, whenmarkets were spooked by fears that Deutsche Bank might miss a coupon. The yieldeased to 7.5% by July 8.
Whilebank bonds have fallen across Europe since the referendum, it is unclearwhether issuance plans will be disrupted, Gildas Surry, a partner at AxiomAlternative Investments, said. "It's too early to say, nobody knows. At this stage,it's a political risk and it has broad ramifications on many fronts — onregulations and balance sheets, on the operating environment," he said inan interview, adding that U.K. banks' subordinated debt yields have risen byabout 40 basis points since June 23.
Lloyds'bond was sold as part of its plans to comply with new rules,designed to ensure bondholders and not taxpayers bear the brunt of bankcollapses.
U.K.banks have to issue large amounts to comply with the TLAC rules over the nextfew years, S&P Global Ratings said July 7, as it for lenders fromthe country.
U.K.banks are more likely to face a drag on earnings than on solvency, as theeconomy should stall rather than enter outright recession, JPMorgan said,adding that bond pricing indicated investors shared this view. Nonetheless,bank debt was primarily supported by expectations of fresh stimulus by centralbanks, it said. The Bank ofEngland has already indicated that it may cut rates and manyanalysts expect the ECB to ease policy.
Moreprudent lending standards and low rates in recent years should limit loan bookdamage to banks from any Brexit slowdown, with credit losses rising from a lowof 14 basis points in 2015 to above 30 in 2016 and 45 in 2017, S&P GlobalRatings said.
WhileBrexit negotiations could lead to a number of negative outcomes for banks, itis possible to imagine benefits for holders of their debt, Surry said. Forexample, if the U.K. implements its own version of global Basel III standards,rather than the EU's, it would be allowed to create more favorable conditionsfor AT1 bonds by reducing the chances of coupon suspensions, he said.
S&PRatings and S&P Global Market Intelligence are owned by S&P Global Inc.