Another dubious ‘first’

After claiming the first contingent capital (Coco) write down - that of Banco Popular in June 2017 - the Spanish banking sector registered yet another dubious ‘first’ for the AT1 market with the non-call of the Santander 6.25 per cent Perp-19 AT1 earlier this week. This event sets a precedent that other issuers with marginally economic or non-economic calls may follow and supports our conviction that this asset classes demands deep due diligence.

The market has long debated the potential for Santander to call this particular AT1 issue and, until very recently, consensus had coalesced around ‘no-call’. However, the recent rally in AT1 bonds and the announcement that Santander was to issue US$1.2bn of new AT1s at the beginning of February threw the consensus into doubt. The thinking was why, when their bucket of AT1s was already full, would Santander issue more AT1 if they did not intend to call.

Setting a precedent

Our calculations showed that an issuance of new AT1s would not cover the gap created by the call of the 6.25s, let alone any growth in Santander’s risk-weighted assets. With the proceeds of the new AT1 issue only due to settle two days before the first call date and the bank restricted from requesting regulatory permission for the call until the new issue settled, it seemed inevitable that the 6.25 bonds would not be called and we remained on the side lines.

On February 12, Santander duly announced that they would not call the notes, but there is a three-monthly call provision in the terms giving them the opportunity to revisit the decision in June. It is possible that they will use this occasion to call the bonds, and that may explain why the notes have traded so robustly despite failing to be called.

It is important to remember that AT1s are governed by Basel III and as such cannot be called for anything other than economic reasons, unless the issuer is over-capitalised. Santander’s 6.25s will switch to a coupon of around 5.55 per cent, a rate marginally cheaper than they could issue a new euro AT1 note. The bank has therefore established a precedent of non-call decisions based on a marginal cost advantage, and given Santander's global presence, peers will have taken notice.

Is this a big deal?

The market has collectively shrugged at this event and, in the trading that followed, the AT1 complex traded up 0.5 per cent with Santander also trading higher. The maturity and resilience of the market has once again been demonstrated since no broader panic has ensued, but is the market right in telling us that this is no big deal? We think there are some important lessons in this event:

1) Understanding at what level the AT1 coupon resets and where this sits relative to the cost of new AT1 capital is critical to determine risk around extending the expected maturity. Low reset bonds deserve to trade at a discount to high resets and investors should hold on to this discipline even when markets become over-exuberant.

2) Nevertheless, investing in ‘busted’ perpetual bonds, where the issuer fails to perform as expected such as failing to call at the first opportunity, is a legitimate strategy so long as the yield to perpetuity is consistent with the investors required return (usually proxied by the cost of equity). However, Santander’s 6.25 per cent notes resets the coupon for the next five years whilst retaining a call option every three months. This stacks the deck in favour of the issuer, exposing investors to plenty of downside but little upside as the bonds will simply be called when it suits Santander.

3) Other structural features, such as the waiver of set-off rights (the right of lenders to seize certain assets of borrowers in case of default), may incentivise an early call even where it is uneconomic due to loss of regulatory capital treatment.

4) Reputation matters. Santander’s non-call decision confirms a long-held belief by the market that the bank will remain focused on paying the cheapest spread irrespective of the cost to its reputation. Even the AT1 notes issued last week has yet to trade above its issuance price. Other issuers may take a less parsimonious approach, to the extent permitted by the regulator.

In addition to the importance of applying rigorous due diligence when investing in AT1 bonds, the economics around calls and post-call valuations has taken on a new level of significance. Within this framework, we believe there are opportunities for investors to profit from valuation anomalies.