REFILE-Investors face buy-back dilemma as capital hunt begins

(Refile to change percentage figure in Irish bank bonds losses)

By Helene Durand

LONDON, Oct 21 (IFR) - Subordinated debt investors are likely to face tough decisions in the coming weeks as banks seek to buy back bank capital instruments at prices well below par or exchange them into equity in order to boost their core Tier 1 ratio and they need to decide whether to accept or not.

While buying back instruments at deep discounts to par is not a new technique and was widely used by banks in 2009 to create billions worth of core Tier 1, investors' decision-making is a lot more difficult this time as the risk of being bailed-in has increased considerably following the introduction of various resolution regimes in Europe.

BPCE and Banco Espirito Santo (BES) were the latest banks to announce liability management exercises this week and expectations from bankers are that more will follow.

European authorities appear to favour the use of private sources of capital, including through restructuring and conversion of debt into equity instruments, before any public money is injected into the banks.

"Whether you participate in these exercises very much depends on your perspective as an investor," said Folkert Jan van der Veer, financials analyst at Cairn Capital.

"If for example you are not keen to incur losses on your position and you think BPCE is a good bank and that the bonds will ultimately be called, then you will keep hold of the bonds. So if you don't participate, you have to be confident that a bank is of good quality, will be around at the time of the call date, and has a strong incentive to exercise the call option."

Andrew Fraser, investment director at Standard Life, added that away from the stronger banks where there would unlikely be buy backs below par and distressed banks in countries such as Spain and Portugal where the risk was to see a coupon switched off for perpetuity, there was a broad band of banks where making any decision wouldn't be straightforward.

"Investors there will have different views on each credit," he said. "I don't think the authorities will go down the coercive route as a first step but this will be at the back of investors' minds and there's always the possibility that coupons could be switched off. Also, as we saw Ireland, it doesn't take long to enact a resolution regime."

In the case of the Irish banks, bondholders had many opportunities to participate in liability management on a voluntary basis at a premium over secondaries until the authorities cracked down on subordinated debt and imposed severe losses at the end of last year, in some cases taking securities out at 10% of par.

"There is clearly a fear that a more coercive approach could be used further down the line," said Van der Veer. "If something goes wrong, or banks have no access to private capital and regulators are less willing to put taxpayers' money into a bank, it will be easier to go down the coercive route. The threat clearly is there in Europe."

PUSHING FOR CORE

BPCE is offering to buy back up to EUR1.8bn of four Tier 1 issues callable between 2014 and 2017. Depending on the priority order, the premium versus secondaries before the announcement was between six and 13 points.

Depending on the investor take-up, the exercise could create between 15bp and 20bp of core Tier 1 although the bank could see its overall Tier 1 ratio drop by 35bp.

"It's interesting that BPCE has been allowed by the French regulator to buy-back its subordinated debt and there seems to be a shift in regulators' focus on core Tier 1 rather than total Tier 1," said Standard Life's Fraser.

"While the transaction is likely to create some core Tier 1, the overall ratio will drop but BPCE will generate real loss-bearing capital."

Given that the bank is not listed and can't go to the equity market, this is an effective way of strengthening its capital base.

"The timing of BPCE is quite interesting and there is likely an element of them trying to pre-empt calls to raise more capital," said Cairn's Van der Veer. "I don't think it's a coincidence and one of the reasons why we have seen Tier 1 prices go down recently is because of concerns around banks' levels of capitalisation. If people question how well capitalised you are as a bank and you are restricted in terms of what you can do, then liability management is a good way to generate core capital."

BES's announcement that it is seeking to exchange six hybrid securities into shares is also a way for the bank to boost its capital.

Under the exercise, the bank aims to raise up to EUR791m of core Tier 1. If the bank gets a 100% take-up rate, as much as 147bp of core Tier 1 would be created.

Under the terms of Portugal's EUR78bn EU/IMF bailout, banks have to boost their core Tier 1 capital ratios to 9% by the year-end and to 10% by end-2012. While it is not the first time BES has conducted a liability management on its hybrid debt, it is the first time it has offered investors the chance to swap into equity.

"The route taken by BES is interesting as by doing a pure debt for equity swap, they don't have to put any cash upfront, there's far less execution risk, less dilution and they don't need underwritters to take on the risk," said Standard Life's Fraser.

A BROAD UNIVERSE

According to a research note published by JP Morgan at the end of September, there is still a large universe of securities outstanding. The estimate is at USD577bn split across Lower Tier 2 (49%), Upper Tier 2 (11%) and Tier 1 (40%).

JP Morgan analysts wrote that in the event of a zero-premium tender exercise undertaken by European banks, a total of USD138bn would be created on a pre-tax basis with USD69bn raised with a 50% take-up.

The note added that if issuers include a premium in order to buy back the debt, assuming a five points premium, a 50% acceptance rate and a 20% tax-rate, the net capital gain on a post-tax basis would be EUR43bn. (Reporting by Helene Durand, Editing by Sudip Roy)