* Ukrainian crisis underlined risks in banks' bond drive
* Banks issuing bonds to boost defences against potential losses
* Bankers still expect 2014 to be a record year for such bonds
By Steve Slater and Aimee Donnellan
LONDON, March 25 (Reuters/IFR) - European banks such as Societe Generale, Credit Agricole and Unicredit will likely have to pay investors a higher return to buy the risky bonds that banks use to strengthen their balance sheets after the crisis in Ukraine forces a rethink about the potential dangers from such investments.
So far this year, European banks have sold over 7.5 billion euros of bonds to boost their core financial strength and bankers expect that tally to reach a record 40 billion euros for 2014 as mainstream investors such as insurers and pension funds, who need to boost returns, buy more of them.
But KBC Bank's sale of 1.4 billion euros worth of such bonds at an interest rate of 5.625 percent, the lowest ever offered despite the Belgian bank's chequered past, could mark the end of the sweet spot for banks hoping to sell such debt at rock bottom rates.
The KBC paper, issued two weeks ago, has dropped over 2 percentage points in the secondary market as a standoff between Russia and the West over Ukraine has increased volatility across financial markets and alarmed investors who fear banks could suffer disproportionately.
When volatility strikes markets, these so-called Additional Tier 1 (AT1) bonds are among the first to sell-off because they are riskier investments. When a bank gets into trouble its AT 1 bonds usually either convert into bank shares or are temporarily wiped out.
"We are confident that banks like KBC are well on the road to recovery but the coupons that are on offer are not reflecting the risk profile of the instruments," said Satish Pulle, lead portfolio manager at ECM, a fixed income house that has around $8.2 billion of assets under management.
"We need to be demanding more yield to protect ourselves from volatility."
Investors offered 7 billion euros worth of orders for the KBC issue, enabling the bank, which had to be bailed out by Belgium during the financial crisis, to offer a rate 2 percentage points lower than similar issues just a few months earlier.
On a 1 billion euro issue, a bank would pay 10 million euros a year for each extra percentage point of interest it pays.
Banks are pricing these bonds cheaply and investors are now reassessing the credit risk.
"These are really risky instruments with complicated structures and not every bank that has issued them is in a great position," said one banker who specialises in such debt.
Europe's banks are expected to issue up to 240 billion euros of AT1 bonds in the next five years after regulators said they can hold AT1 bonds equivalent to 1.5 percent of their assets. The bonds are cheaper to issue than shares, which are also used to strengthen banks' balance sheets.
"Given the amount of potential supply over the next few years there's clearly the possibility for markets to get congested from time to time," said Simon McGeary, managing director for new products at Citigroup in London.
"The last few weeks has really been the first test of that with several deals in the market simultaneously."
The potential market could be swelled even further if regulators force banks to increase their leverage ratios, which could spur the likes of Deutsche Bank or Barclays to bump up their issuance.
The aim is to create an extra layer of protection to prevent a repeat of the 2007-2009 financial crisis when taxpayers bore the brunt of bank bailouts.
About 35 billion euros of AT1 bonds have been issued since the financial crisis. This week, French banks Societe Generale and Credit Agricole said they planned more sales and Italy's UniCredit started a roadshow for investors on Monday and is expected to raise about 2 billion euros from an issue.
HSBC, Deutsche Bank, Barclays, Commerzbank and Nordic lenders also all seem poised to follow and sells billions of euros worth.
The bonds have commonly paid interest of 6-9 percent, an attractive rate given central banks have kept rates close to zero. But that higher interest rate reflects a risk that investors could lose their money, or end up owning shares they may not want.
To avoid retail investors getting stung by such exposure, the regulator in Britain has made it clear it does not want such bonds sold to them. Two deals this year from Nationwide and Lloyds were structured to keep small investors away.
Sweden's regulator could also dampen demand for such bonds if it sets the "trigger" at which the bonds convert into shares or are wiped out at a very high rate, making it more likely investors will be hit.
Bankers said Stockholm could decide that AT1 bonds convert into shares in a bank or are temporarily wiped out when the money that the bank has set aside to cover potential future losses shrinks to 10 percent of its risk weighted assets compared to 7 percent in most countries. (Additional reporting by Helene Durand at IFR. Editing by Carmel Crimmins and Giles Elgood)