But investors are burned out.
By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.
After countless scandals, near-death collapses, bail-outs and bail-ins, Italian lenders are finding it increasingly difficult to attract investors. The amount of Italian bank bonds outstanding has shrunk by about 30% since the start of 2015, according to Marcello Minenna, the head of Quantitative Analysis and Financial Innovation at Consob, the Italian securities regulator.
The decline in volumes has been accompanied by rising yields on subordinated and senior unsecured notes. This is a big problem in a country where bonds represent an important share of banks’ liabilities, especially at a time when the big European banks are facing increasing regulatory pressure to issue ever larger volumes of what has come to be known as “bailinable (as in bail-in-able) debt.”
Bailinable debt traditionally consists of hybrid debt securities that automatically convert into equity and/or have their face value mercilessly slashed if some pre-defined trigger is met (usually linked to the issuer’s capital). It includes subordinated debt and high-risk instruments like the contingent convertible (CoCo) bonds that are designed to be bailed in first when a bank gets in trouble.
Bailinable debt comes into play when a bank is about to go belly up. Part or all of the debt can be used to “bail in” a bank’s investors before taxpayers are called upon to cough up the rest. It’s what should have happened from the early stages of the financial crisis. But for bankers there’s a big problem with this kind of debt: given its high associated risks, it normally comes with a hefty price tag, particularly if the bank in question fails to inspire confidence among investors.
To get around that problem, financial engineers in France conjured into existence a whole new debt class in 2016 called senior non-preferred bonds (AKA senior junior, senior subordinated or Tier 3), which were hastily accepted by France’s market regulators, endorsed by the European Commission, given a stamp of approval by rating agencies, and fast-tracked into use by France’s four Too-Big-to-Fail banks, which were desperate to fill an estimated eligible capital shortfall of €50 billion.
The newfangled debt class was positioned in the hierarchy of creditors between subordinated debt and the pre-existing senior unsecured debt. Its holders would be subject to bail in before senior bondholders (who apparently won’t be bailed in at all) but after junior bondholders. In other words, the senior non-preferred bond pretends to be simultaneously one thing (senior), in order to keep the yield (and the cost for the bank) down, and another (junior) in order to qualify as bailinable.
It’s a way for big banks to bamboozle bondholders – usually institutional investors like our beaten-down pension funds – into buying something with other people’s money that doesn’t yield nearly enough to compensate them for the risks they’re taking. And for the moment it appears to be working.
In its first issuance of senior non-preferred bonds, Credit Agricole only paid about 45 basis points more than it would to sell traditional senior debt and about 65 basis points less than it would for subordinated. Since then, the practice has spread beyond French borders. Early this year Holland’s ING and Spain’s Santander began issuing senior non-preferred bonds even though their issuance had not yet been officially sanctioned by each bank’s respective national regulator.
In June Spain’s government hurriedly passed a law endorsing the new financial instruments. In the interim Santander has issued its second €2.5 billion batch of the bonds and has plans to issue a whole lot more. In August Spain’s second biggest bank, BBVA, placed €1.5 billion worth of senior non-preferred bonds, apparently “at the best price ever” in Europe (from the bank’s perspective), according to BBVA’s own website.
Now, it’s the turn of Italy’s struggling lenders to join the party. On December 28, the Italian Parliament approved the Italian Budget Law for the 2018, which provides, among other things, for amendments to Italian laws aimed at permitting the issuance by Italian banks of “non preferred” senior bonds. Italy’s fragile super bank, Unicredit, has been chomping at the bit to issue such bonds. Soon it will get the chance, but will investors buy them at a low enough yield?
Fears about the health of Italy’s toxic debt-laden banking system still abound despite the controversial rescue last summer of Monte dei Paschi di Siena (MPS) and the resolution of Popolare di Vicenza and Veneto Banca. There are few better barometers of investor sentiment than the shares of “rescued” Monte dei Paschi, which have done nothing but lose value since resuming trading at the end of October. On Friday they closed trading at €3.93, a far cry from the €6.49 a share the Italian government paid in August when it injected €3.85 billion into the bank to keep it alive.
Against this backdrop, Italian banks will need to raise as much bailinable debt as possible over the coming months. Recent simulations performed on the top 162 EU banks in terms of Tier 1 capital showed that Italian banks have minimum required eligible liabilities (MREL) of between 11.7% and 13.3% of total assets, considerably higher than their French, German or even Spanish counterparts. Under the new EU rules Italian banks will need to add between €79 and €111 billion in subordinated debt financing.
It’s a tall order, especially after the bail-in of €5 billion of subordinated bonds this summer. Investors are already smarting and as Marcello Minenna, the head of Quantitative Analysis and Financial Innovation at the Italian securities regulator, warns, the new class of non-preferred bonds may simply be seen as subordinated bonds under a different name, and what’s more offering lower yields.
While yield-starved investors may be desperate for returns of just about any kind after years of heretofore unprecedented financial repression, there’s still a limit to what they’ll buy. While that limit may be ridiculously low, it could soon be tested in Italy, especially now that the only marginal buyer of Italian sovereign debt, the European Central Bank, is poised to withdraw from the market, which could trigger a whole new round of fear and mayhem in the Euro Zone’s third largest economy. By Don Quijones.
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