Brazil lenders rush to raise Tier 2 capital

Aug 3 (IFR) - Itau Unibanco's hefty new US$1.375bn subordinated 10-year bond this week added momentum to the rush among Brazilian lenders to raise Tier 2 capital under the current format before such paper becomes obsolete in 2013.

Accounts spied rarity value in a bond that regulators are putting out to pasture at the end of this year, as the Central Bank looks to force financial institutions to issue Basel III-compliant debt.

More FIs are expected to come with Tier 2 bonds, mostly because they will ultimately be cheaper than the higher premiums investors will charge for new Basel III-compliant structures.

"Banks are issuing a lot of Tier 2, as they don't know what they will be able to issue and Tier 2 is less expensive," said a corporate credit analyst.

This comes after several Tier 2 issuances already this year, including a US$1bn 5.75% 10-year from Bradesco, a US$750m 5.875% 10-year from Banco do Brasil and a US$500m retap by Itau of its 6.2% Tier 2 2021s, which came with 6% yield.

Itau bettered such pricing this week. It was seen offering 20.0bp-37.5bp over the existing Tier 2 2022s after releasing revised guidance at 5.500%-5.625%, shrinking that premium to 15bp-20bp when it priced at par to yield 5.5%, or 399.6bp over US Treasuries, on the back of a US$3.3bn book. Joint bookrunners were Itau, JP Morgan and Standard Chartered.

What the Central Bank will qualify as regulatory capital post-December 31 remains unclear, but issuing old Tier 2 bonds still makes sense -- despite the fact that capital recognition on such debt will start amortizing at 10% a year in 2013.

This is based on a bank's total Tier 2 holdings, so in theory a bank could issue a new Tier 2 before the December 31 deadline, still receive a 100% capital recognition for the first five years, and then see a 20% reduction just as they used to in the past, said one banker.

Yet because these bonds will gradually lose their capital benefits and start looking more like senior debt as time passes, pricing will be key as to whether or not banks will bring such issues in 2012.

One DCM official reckons that the spread differential between sub and senior debt will have to remain in the 75bp-100bp range for such offerings to remain cost effective.

LIKE EQUITY

Either way, new Basel III-compliant Tier 1 and Tier 2 bonds are expected to carry structures that make them more equity-like and hence more expensive.

Going forward, Tier II notes may also carry loss absorption clauses that will allow banks to write down the debt completely, though they would have more headroom than Tier I notes before capital ratios are breached, say some bankers.

This means that pricing will likely be closer to the recent Tier I perps issued by Banco do Brasil, which has so far been the standard bearer for bond offerings that will conform to the new regulatory environment.

Those perps, which had a floating indenture to adapt to the new rules, showed in February that investors were willing to accept the risks inherent in structures that comply with Basel III, but pricing still remains more art than science. Those bonds were priced to yield 9.25%, but have since tightened to around 8.25%-8.50%.

At the time, the spread differential between Banco do Brasil's Basel III-compliants and its other hybrid perps hinted at just how much more the banks would have to pay to raise this new type of regulatory capital. For instance, that spread was some 300bp, but has since shrunk to around 150bp.

Because perps are riskier, the spread differential between old and new Tier 2 bonds would probably be less than 150bp, said one DCM official.

Another official thought that new Tier 2 bonds would come some 150bp inside a comparable Tier 1 Basel III-compliant instrument, which for Banco do Brasil would currently mean a yield of around 6.75%. Top tier private banks would perhaps pay 25bp-50bp inside of that.

While yields may seem higher, the equity-like nature of Tier 1 and other Basel III-compliant bonds may mean borrowers will use different benchmarks.

"In the new world, if you do Tier 1, the comparison will be return on equity as opposed to what they pay on debt," said a senior DCM banker.

For others, these new instruments will be firmly in the debt camp, given the considerably higher cost of equity for a name like Banco do Brasil.

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