Everything you want to know about call risk - Part 2

This week we look at the decision process bank and insurance issuers take when deciding whether to call or extend their subordinated debt and Tier 1/hybrid securities.

As detailed in last week’s article the term “call risk” refers to the risk that an issuer will decide not to call or redeem a security at the first possible call date (and any subsequent interest payment date when a call is generally possible). In doing so the issuer has extended the term of the maturity.

There are two types of calls:

1. Issuer call - this is a common feature of many bonds and hybrids and provides the issuer with an early redemption option. This allows the issuer to elect to repay the bond or hybrid principal on a defined date(s) prior to the maturity date.
2. Investor call - less common than the issuer call, this is an option for the investor to require the issuer to repay the principal prior to the maturity date. A variation exists in hybrids where the investor can require conversion into ordinary equity that the investor must then sell on market to receive principal return of the funds they originally invested.

In the vast majority of subordinated bonds and Tier 1 securities that trade in the over the counter (OTC) and listed market, the documentation only allows for an issuer call. The investor has no say in the call decision; rather the power is with the issuer.

The following covers the decision process that a bank or insurance issuer will follow when considering whether to exercise an issuer call or not, both at the first possible call date and any subsequent call date as allowed under the issue documentation. Corporate issuers will generally focus purely on the cost to reissue/economic decision as they are not regular issuers in the market.

The call decision

In making the decision whether to exercise the call option, the bank or insurance company will consider the cost of replacement capital, market reputation and the regulatory environment at the call date.

Cost to reissue - the issuer will examine the cost to reissue their debt at the call date versus keeping the current debt outstanding. This will depend on any step-ups in the existing security and credit markets at the time of call.

Typically speaking, subordinated debt or Tier 1 hybrids issued prior to the GFC are very cheap funding (even after a step-up margin is added). From an economic point of view, extending many of these pre-GFC issues would be significantly cheaper than replacement funding in the current market.

As an example, Macquarie Bank issued a ten year non-call five year subordinated bond in May 2007 with a coupon of 35bps over BBSW and if not called in May 2012 it would have stepped-up to a new margin of just 85bps over BBSW. Had Macquarie Bank raised a new subordinated bond in May 2012, we estimate the cost would have been at least 375bps over BBSW given the majors had recently raised ASX listed subordinated debt at a margin of +275bps. Despite the low cost to extend, Macquarie Bank decided to call the bond, mainly on reputation and regulatory grounds as detailed below.

Conversely subordinated debt and Tier 1 issues raised post GFC typically have very high credit margins and large step-ups if not called which provide a strong economic incentive to be called and replaced with cheaper funding. For example Bank of Queensland issued a ten year non-call five year subordinated bond in June 2008 with a coupon of 310bps over BBSW. If not called in June 2013 will step up to a new margin of 410bps over BBSW making it expensive funding and more likely to be called and replaced with something cheaper.

With the majority of existing subordinated debt and particularly Tier 1 hybrid securities issued pre-GFC, the cost of funding assessment provides an economic case for banks and insurers to extend the maturity and pay a relatively small “penalty rate”. However, this argument is overshadowed by the two remaining opposing factors.  

Reputation and access to market - in the professional investor markets there is often an expectation that issuers will exercise their call option at the first available date. This applies to the subordinated bond and international Tier 1 markets. When an issuer's bonds were initially sold to investors it was based on pricing the credit risk to the call date so any extension beyond this date means investors have not received adequate compensation (in the form of coupon margins) for the increased term (although Basel III and APRA are trying to remove this expectation of call for future callable bond issues).

As the issuers of these securities are banks and insurers and require ongoing access to the global debt markets it would be very damaging for an issuer's reputation to not exercise their call option. An example of this is Deutsche Bank who did not call one of their bonds during the global financial crisis and found it difficult and more expensive to issue new bonds when they returned to the market.

This reputational risk is not as prevalent in the retail hybrid market as it is in the professional institutional market where OTC bonds trade (nor the corporate market where the companies are less reliant on ongoing access to debt markets).

This is currently the most important factor for banks and insurers in the call decision. We often hear Australian banks and insurers saying they are not going to be the first institution in Australia not to call a step-up security. They don’t want the damage to their reputation. However, the big risk here, albeit small, is that a number of institutions make the decision not to call and then safety in numbers may mean the norm becomes that no one calls and the market can’t single out specific issuers for not calling. In Europe the stigma attached to not calling has reduced somewhat as a number of organisations have been prevented by regulators or in the case of Ireland, Italy and Spain, simply unable to afford to call. But in Australia, the reputational risk remains high with no major bank, regional bank or large insurance company not calling their step-up callable securities.

Regulatory environment – all regulatory capital instruments i.e. Tier 1/hybrid securities and Tier 2/subordinated debt must first receive regulatory approval before they can be called. So it is very important to note that if a bank or insurance company is struggling a little and/or the regulator is concerned with the institutions’ level of capital, they may not allow a callable security to be redeemed at its first date. Whilst rare, it has occurred in European markets since the GFC

There are also changes to prudential requirements for banks and insurers that alter the classification of the security as regulatory capital that may require the issuer to exercise their call option. For example, from 2013 Basel III will establish that step-ups in Tier 1 (hybrids) and Tier 2 (subordinated debt) will make a security ineligible as regulatory capital once it passes its first call date and accordingly, we expect banks to call their existing securities with this feature at the first call date, unless the economic incentive not to call becomes very strong and/or there is a dramatic shift in the reputational landscape.

Back in September 2011 we wrote an article "APRA announce further details on capital - Positive for step-ups" which included the following statement from APRA regarding its intention to phase-out all "old style" step-up capital securities at their first call date which includes both subordinated debt and Tier 1 hybrids.

Outstanding non-complying instruments will be required to be phased-out no later than their first available call date, where one exists

Under Basel III and APRA's proposed capital standards, bank step-up securities would get no capital weighting towards the capital ratio calculations once they pass their step-up date. We viewed this as a strong incentive for the banks to call at first opportunity. However, APRA have used even stronger language in saying such non-complying securities "will be required to be phased-out no later than their first available call date."

There are also Tier 1/hybrid and Tier 2/subordinated debt securities that do not have step-up clauses. We view these securities less likely to be called on all three grounds:

1. They are typically cheap to maintain as were generally issued pre-GFC at low credit margins that don’t alter once the first call date is passed
2. The reputation risk is lower as they were not initially sold with the same expectation of call at first opportunity as the step-up securities were
3. The regulatory environment is not pushing for these to be called or eliminated

There also exists an additional APRA capital rule that has implications for subordinated debt issues only (and is similar in other jurisdictions). Tier 2 subordinated debt securities contribute to the calculation of a bank or insurance company’s regulatory capital ratios. However, this weighting falls by 20% each year in the last four years prior to maturity. As such it’s weighting and capital contribution in the total capital ratio calculation falls as maturity approaches. This typically kicks in one year after the first call date and in the unlikely event a subordinated debt issue is not called at first opportunity does provide some incentive to call in the ensuing years and before legal final maturity.

Accounting and tax treatment of the security may also influence an issuer's decision to call securities.

Rollover or exchange for a new security - this is another option for issuers and one that we have witnessed in Europe to the detriment of investors. Distressed European banks have called or exchanged the securities at the prevailing market value resulting in investors crystallising losses. In institutional markets this damages an issuer's reputation as the exchange favours the issuer and is often referred to as a coercive exchange. In Australia, Goodman's have used this option despite continuing to be rated and this precedence is not one that we would like to see become commonplace in the hybrid market.

Conclusion

As you can see, call structures and the likelihood of the call being exercised differ across securities and issuers and must be assessed on a case by case basis. There are many considerations into the call decision and whilst a past history of call is an important factor it cannot be relied on blindly.

The decision process is considered more complicated for financial institutions as compared with corporations, the latter mainly assessing the economic cost of replacement funding and possibly the impact on credit ratings.

Next week we will look at what can happen to prices should the market believe an issuer will no longer call at the first opportunity.