NEW YORK, Aug 17 (IFR) - A sell-out bond by JP Morgan this month, which some see as a game-changer for the way US banks approach their capital shortfalls, has stirred up demand from the buyside.
Investors poured some US$5.5bn of orders into JP Morgan’s US$2.5bn senior holdco trade, the first to use a call feature to tackle Total Loss Absorbing Capacity (TLAC) rules.
The trade, which priced on August 3, has a final five-year maturity but is callable after four years.
While it’s unclear whether such deals will pass muster with regulators - expected to release the final rules by the end of the year - investors are keen to get their hands on more.
“People are talking about it and we’ve received reverse enquiry from investors on this structure,” one head of syndicate told IFR.
“It could effectively replace traditional bullet securities for TLAC issuers.”
Banks could potentially cut the cost of complying with TLAC by using call features.
Under the proposed rules, debt receives 50% less TLAC treatment when it has less than two years until maturity, dropping to zero when it has less than one year remaining.
Call features would theoretically allow issuers to redeem bonds early, before they lose TLAC treatment. That would save them paying interest on debt with no regulatory benefit.
So long as regulators do not treat the call date as the final maturity date - which would nullify the intended benefit - some analysts reckon callable structures could become the preferred choice for banks going forward.
“Assuming it will qualify [for TLAC], from an issuer standpoint it makes a lot of sense to have this feature embedded,” said Pri de Silva, senior analyst at CreditSights.
“This could become the de facto form of long term bank debt.”
TLAC requires banks to hold minimum amounts of long term debt that regulators can write off to absorb losses when a bank fails.
JP Morgan has a US$20bn TLAC shortfall as of February, the second biggest of all US banks after Wells Fargo.
JP Morgan declined to comment on its new deal, but investors and rival bankers said the hope was that regulators would overlook the call option and count it as a five-year trade.
That would give it TLAC treatment in 2019, when the regulations come into effect, but with the option to call the debt in 2020, before it loses TLAC treatment.
The proposed TLAC rules offer no explicit penalties for the use of call options - but JP Morgan did have to pay up to add the call feature.
The deal priced at T+123bp, around 25bp outside where the bank’s existing five-year bonds were trading - but it rallied sharply in secondary and was trading at T+103bp on Wednesday.
Accounting for a new issue premium of 10bp, bankers and investors put the price of the call option on the JP Morgan deal at around 15bp.
“I looked at it as free money,” said a buyside trader who bought the deal.
“You should be treating it like a four-year bullet maturity because the probability they call it is very high.”
Copycat issuers may well need to offer slightly less in the way of concession as investors get used to the structure, said bankers.
But if the deals are to fully take off, regulators will need to give the nod.
Under the current proposals, investor put options - the use of which is out of the issuer’s control - count as a deal’s final maturity date.
But the rules do not specify any restrictions on the use of call options, which is at the discretion of the issuer itself.
The rules do, however, state that banks would need the Federal Reserve’s approval to redeem or repurchase TLAC debt if doing so would take them below their minimum TLAC requirement.
The regulations also state that the phasing out of TLAC treatment in the final two years of maturity is intended to reduce the amount of loss-absorbing debt that could mature while a failing bank is being resolved.
In such a situation, analysts said banks would be unlikely to exercise the call option anyway, because they would face challenges refinancing the debt.
“From [the regulator’s] perspective they are concerned about capital being there when it is needed,” said a credit strategist.
“If a bank is facing challenges, it won’t call the bond. So in the scenario that the regulator cares about, it is actually a five-year bond,” he added, referring to JP Morgan’s deal. (Reporting by Will Caiger-Smith; Editing by Natalie Harrison and Marc Carnegie)