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T3 take-off: a new market for European credit emerges

The post-2008 regulatory shake-up of financial institution capital structures has created a wealth of opportunities for credit investors. Now critical changes in the capital requirements for European banks and insurers put tier-3 debt deals firmly on the table. With banks moving at different speeds towards the regulators’ ultimate goal of harmonisation, credit investors seeking to capture attractive new issuance must be aware of new developments.

European banks: Reshuffling capital structures at regulators’ request

The spectre of a global systemic banking collapse, made almost real at the peak of the 2008 financial crisis, continues to haunt regulators around the world. For instance, in an attempt to shore up bank balance sheets, regulatory authorities are trying to upgrade the Basel Accords to set higher international standards for capital adequacy.

However, progress on version IV of the Basel agreement – currently on the committee to-do list – has been sluggish. Nevertheless, while Basel talks may have been sidelined for now, global authorities are making headway on common standards for so-called resolution capital – also known as total loss-absorbing capital (TLAC). It represents a shift in focus from considering common equity tier 1 (CET1), the purest form of equity, to one that takes a more comprehensive view of an institution’s capital.

This change in perspective has driven the UK Financial Stability Board (FSB) to zero in on the so-called too-big-to-fail, globally systemically important banks (G-SIBs) – the large financial conglomerates offering an array of services worldwide – with a set of proposals to further shockproof the banking system.

Under the FSB’s TLAC standards, which are due to be implemented from 2019, G-SIBs will be required to boost capital and leverage ratios to ensure they can maintain core functions during an internal crisis without threatening broader financial stability and, importantly, calling on taxpayer-funded bail outs. Instead, the TLAC requirements aim to create a ‘bail-in’ scenario for G-SIBs facing a bank resolution process, which may include converting some liabilities into capital or writing them down.

To meet the new bail-in standards, all European G-SIBs may have to substantially reshape their respective liability and capital structures under the terms defined by the FSB’s TLAC term sheet. All other European lenders will need to change their capital structures to meet the European Banking Authority’s minimum requirement for eligible liabilities (MREL) framework.

The MREL proposals essentially mirror the TLAC requirements: that is, ‘bail-in’ assets should at least constitute 16% of a bank’s risk-weighted assets (RWA) from 1 January 2019, and 18% from 1 January 2022. The proposed rules also stipulate that loss-absorbing assets should account for 6% of the leverage-ratio denominator from 1 January 2019, before rising to 6.75% three years later.

MREL-eligible liabilities are required to be statutorily-, contractually or structurally-subordinated to exclude liabilities (see graphic for definitions of these types of subordination). They also must not be issued by a special-purpose entity, which have been used in the past to isolate banks from specific financial risks.

Despite their technical nuances, both TLAC and MREL serve the same purpose: to ensure that the financial institutions in question have an adequate level of loss-absorbing and recapitalisation resources available to weather a crisis. Principally, they have been designed to keep vital bank operations functioning in the event of failure without calling on taxpayer funding to keep them afloat.

Implementation issues: In search of a level playing field for banks

To date, several countries within the European Union have adopted different interpretations of the TLAC and MREL standards, with most of the variation occurring beyond the tier 2 debt level in the mix of instruments that typically includes senior and subordinated debt, corporate deposits, derivatives and other operational liabilities

For instance, Spain has proposed including tier 3 (T3) debt, which is absent from the Italian and German models. Last year, too, France introduced a law that will see banks able to issue bail-in-eligible T3 notes, which rank between senior and subordinated bonds.

All up, the TLAC and MREL regimes promise to be game changers for European banks, with massive debt issuances likely to be made prior to the implementation deadline. For credit investors, a burgeoning market for T3 and other alternative fixed-income instruments could see higher spreads on offer – albeit requiring a sharp focus on bank fundamentals to manage risk and identify opportunities.

As the new bail-in rules become established, greater issuance of TLAC- and MREL-compliant paper should see a marked reduction across the board in the level of new ‘vanilla’ senior unsecured mid-to-long-term bank debt. This reduced supply, combined with large buffers of subordinated and senior non-preferred debt, should drive down the cost of capital.

But the adjustment to the common TLAC and MREL rules will be felt differently across Europe as the various jurisdictions become aligned with the new requirements. For example, French and Dutch banks are notably expected to be one of the few large European issuers of senior -unsecured debt in the new environment. Germany and Italy – which introduced depositor preference from 2017 and 2019, respectively – will also rely on senior-unsecured issuance to meet the new obligations.

At a recent conference call with credit analysts, Deutsche Bank highlighted how the TLAC and MREL proposals are spurring changes in law to bring the currently diverse national arrangements under a common regime. According to the bank, the move to harmonise bank insolvency standards across Europe could “see changes [in Germany], which would add an additional funding option to the toolbox, namely preferred plain vanilla senior debt […] The current law does not allow the bank to issue senior preferred today, but it is expected that an instrument would be put in place through legislation for the future.”

The emergence of T3 debt: Variations in implementation across Europe (click to see a larger version of the diagram)

Source: Hermes, Société Générale as at February 2017

Although German banks will have to adjust their senior non-preferred debt arrangements to fully comply with MREL/TLAC rules, existing senior debt would likely be grandfathered and remain eligible for bail-in purposes, the bank said. Based on current expectations, Deutsche Bank itself holds €116bn of TLAC-eligible liabilities – equating to 33% of its RWA (and 9% of its leverage exposure), or a buffer of €35bn above the 2019 requirements.

On the market: current TLAC bank issuance

For credit investors, the sea-change in European bank debt issuance creates plenty of new opportunities – particularly at the T3 level.

Across the continent, European banks are already issuing new TLAC paper in the form of senior debt issued by their holding companies – known as senior HoldCo – and T3 debt to comply with the new bail-in regime. For example, French giant BNP Paribas has signaled plans to issue €10bn of senior non-preferred or T3 debt annually for the next three-to-five years. Fellow French institutions, Société Générale and BPCE, have also confirmed their intentions to issue TLAC-compliant debt to the tune of €9bn and €1.5 to €3.5bn, respectively. In the case of Société Générale, €2.1bn of TLAC paper has already transacted.

Dutch bank ING has also joined the TLAC game, recently issuing €750m of T2 HoldCo debt (priced at mid-swaps plus 215bps) to help meet bail-in requirements. ING has elsewhere flagged plans to shift some operating company, or OpCo, debt into the HoldCo structure to bolster its compliance with the new regime.

Adjusting for mis-matching maturities, T3 notes trade at half the spread of T2 paper. But within the T3 market, the strongest banks should eventually see the spreads on their T3 debt being about one quarter as high as for T2 issuance, which could generate mispricing opportunities in the T2 market.

T3 transition: Smooth moves by European insurers

As regulator-prompted banks explore new debt-funding avenues up and down their capital structures, European insurers also seek innovative ways to finance their liabilities, including T3 debt issuance.

Unlike banks, though, insurers’ T3 characteristics (see box below) tend to be the same across borders, particularly following the recent introduction of the European regulatory harmonisation for the industry – known as Solvency II.

In October 2016, French insurer Caisse Nationale de Prevoyance (CNP) issued the first euro-denominated T3 deal under the Solvency II regime. (Technically, though, CNP wasn’t the first to arrive at the European T3 party, following a Canadian dollar-denominated issue by Aviva in April of the same year. Aviva raised C$450m with a 4.5% coupon, with the bond maturing in 2021.) CNP attracted €1bn in the deal, which included a six-year bullet bond (ie, non-callable), with no-optional deferral and a mandatory coupon deferral linked to a minimum capital requirement breach.

From a bondholder’s point of view, T3 offers a safer structure than T2. For CNP, the deal presented a more optimal way to raise resolution capital. With no rating from Standard & Poor’s, the CNP T3 offer was priced at the mid-swap rate plus 190bps following initial price thoughts, plus 225 bps. This spread eventually tightened given the €7bn order book for the deal.

T3 issuance from European insurers should gain further traction with UK insurer Phoenix – whose debt we have held for some time – rolling out the first sterling-denominated T3 issue in January this year.

Phoenix sought £300m in the 5.5-year offer, which tightened to the UK Treasury rate plus 337.5bps from about 375bps with an order book exceeding £1.6bn. The company still has room in its T3 bucket, which is capped at £350m, but we feel the next deal could be a T2 issue in order to optimise its capital structure. By the end of the year, Phoenix should hit investment-grade status at the subordinated level, in our view.

T for three: understanding insurance debt rules

In the standard insurance debt hierarchy, T3 sits at the same subordination level as T2. This means that under the criteria T3 does not have to rank senior to T2 but only above Restricted Tier 1 – or RT1 – debt (which is an insurer’s equivalent of a contingent convertible bond or, CoCo).

The classification rules also limit the maturities of T3 paper to at least five years from the issuance date, with those structured as bullet, or non-callable, instruments permitted. In addition to occupying the same level of subordination, T3 debt has the same ‘step up’ restrictions as T2: issuers cannot redeem offers within the first five years unless the bond is exchanged, converted or replaced with a T1, T2 or T3 bond of the same quality or better.

Perhaps the most critical distinguishing feature of T3 issues compared to T2 relates to the mandatory coupon-deferral definitions. For T3 debt, mandatory deferrals kick in following a breach of the minimum capital requirement (MCR) – in which case insurance and reinsurance undertakings must cease – but are cumulative. For T2 debt, an insurer’s breach of the Solvency Capital Requirement (SCR) – a level of funds enabling it to absorb losses while continuing to operate – triggers mandatory deferrals.

In essence, the MCR threshold – which falls somewhere between 25-45% of the SCR – means that deferral risk for T3 notes is very low compared to Solvency II-compliant T2 paper.

Furthermore, following an SCR breach, an insurer would legally be required to prepare and execute a recovery plan. After an MCR breach, however, the regulator can apply much tougher measures such as restricting the free disposal of assets and ultimately revoking an insurer’s licence.

The Solvency II regulations also limit insurers’ T3 issuance to 15% of the SCR, while combined T2 and T3 capital must not exceed 50% of the same benchmark. While the rules set no minimum for T2 or T3 issuance, T1 debt must comprise at least 50% of the SCR, of which only 20% can be hybrid capital (or RT1, as defined above).

Deferred-tax assets (DTA), the subordinated mutual member accounts and preference shares can also be classified as T3 if they do not meet the classification criteria for T1 or T2. This means that, in practice, T3 capital consists largely of DTA – except for Aviva’s Canadian dollar-denominated 4.5% 2021 bond and the new CNP euro-denominated issue. While some investors argue that the low coupons of T3 subordinated debt could be an incentive to issue more, the DTA route is even cheaper.

Look out for further issues...

Even though insurers’ issuance of T3 debt is limited to 15% of their SCR, and their strong capitalisation allows them to trim their Solvency II requirements by partly replacing grandfathered Tier 1 with senior debt, we expect them to bring more T3 deals to market.

In particular, we anticipate that other French insurers, such as Credit Agricole Assurances, will enter the T3 market. And CNP, too, could issue a follow-up to its successful pioneering offer, given the €1bn capacity left on its books. In the UK, Phoenix and Aviva might also have set an example for other insurers to emulate.

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