Banks should continue to focus their liability management exercises on subordinated debt and forget about covered bonds. As every covered bond practitioner will tell you, the covered bond market has been default-free since Frederick the Great’s reign some 250 year ago. And, if the latest Portuguese covered bond tender result is anything to go by, investors remain as confident in the product as ever.
Subordinated bonds, that are the main target for liability management exercises, will often trade at big discounts to par which means that their potential accretion to core tier one will be higher than a bond that trades close to par.
Despite that, several banks have opted to move up the capital structure and exercise liability management for their outstanding covered bonds. But judging by the paltry take-up of Portuguese borrowers Banco BPI buy-back they shouldnt bother.
BPI only managed to convince 7.5% of investors to take part in its buyback of its split-rated, single-A to triple-B, covered bonds. The borrower had hoped to buy 1bn of the three year bonds at 85% of par but ended up getting just 76.65m.
This may have partly been because the bonds were already trading at around 82.50%, so investors were hardly incentivised to take advantage of the offer which didnt look to generous compared to the 20 or 30 cent premiums usually offered in subordinated debt buybacks, or the 10 cent premium of the National Bank of Greeces recent covered bond tender.
But the low participation might also suggest a degree of investor confidence in the product itself. It also implies investors are prepared to live with lower covered bond ratings.
As the clock ticks down to the European Banking Authoritys June 30 deadline for banks to raise their core tier one capital ratio to 9%, funding teams should devote their precious time to focusing on managing those liabilities that are going to generate the greatest improvement to their capital position. They should leave their covered bonds alone. At the very least, Frederick would not approve.