… is something that can be done by buying European banks’ Tier 1 bonds — even hybrid ones — according to Société Générale credit analysts.
The whole thesis is based, firstly, on the idea that under new regulation (the strengthened Basel II, for instance) many banks will need to raise new capital. So far, so standard — but SocGen also thinks the capital raising will coincide with much higher bank profits (about 20 per cent in 2010) , thereby reducing the risk that coupons won’t be paid.
On the hybrid bond, or subordinated debt, front, SocGen thinks there will still be a market for these equity-like instruments, since the amended EU Capital Requirements Directive still allows for them to make up 15 per cent of banks’ Tier 1 capital.
Here’s the thesis, by analysts Nathalie Deliens and Matthew Maxwell, in a nutshell:
What are the implications for credit investors? The first conclusion is certainly positive, as higher core Tier 1 ratios and a minimum leverage ratio will require banks to raise new equity, creating a layer of protection for holders of subordinated bank debt. The second is also positive as higher RoAs and higher earnings increase the probability that coupons can and will be paid. The third conclusion suggests overall higher risks even though the type of hybrids included in Tier 1 capital will be controlled more strictly. Grandfathering provisions for existing Tier 1 hybrids will give banks time to manage their capital base. However, issuance of mandatory convertible bonds is likely to increase and credit investors will need to understand the risks of these more equity-like instruments.
The idea here, then, is to either find and buy hybrid bonds which have already been priced by the market to miss a few coupons (all based on recent European Commission-inspired confusion), or, identify those banks with reasonably stable earnings but that will nevertheless need to raise new capital.
In SocGen’s opinion, that equates to banks like UniCredit and Crédit Logement. But, just to widen the net out a bit, here’s SocGen’s universe of which banks will and won’t need to raise more capital by 2011 — based on the assumption that regulators will require a core Tier 1 ratio of circa 8 per cent (and leverage of about 3 per cent) and excluding state aid. Click to enlarge:
Related links:
The EC bank debt riddle – Neil Unmack, Reuters
Tear down this hybrid capital wall – FT Alphaville