Yield-hungry investors shirk bail-in bond buffet

Banks fear the buy-side’s appetite for MREL debt is on the wane

Bail-in bonds flooded the market following the adoption of the European Union’s Bank Recovery and Resolution Directive (BRRD) in 2014, which compelled lenders to issue mountains of debt capable of absorbing losses if they run into trouble.

Now, the market seems to have reached saturation point – just as the deadline for meeting bail-in buffer amounts, known as minimum requirements for eligible liabilities (MREL), approaches.  

An analysis by the Single Resolution Board, using December 2016 data, found that banks had an MREL shortfall of €117 billion ($129.5 billion), of which €47 billion would need to be met with instruments explicitly subordinated to other liabilities. The European Banking Authority found banks had issued €4.5 billion of eligible instruments in 2016.

Even more will have to be issued to satisfy changes introduced by BRRD II, an update to the initial resolution rules that becomes effective as of December 2020. The revised directive requires bail-in debt to have a greater level of subordination, meaning certain instruments outstanding may become ineligible.

Banks have until 2024 to meet their fully loaded requirements, although they will have to comply with transitional targets in the interim.

That’s a lot of debt looking for a home in a short space of time. But banks are now worried that investors have already had their fill of bail-in bonds.

Respondents to the EBA’s latest Risk Assessment Questionnaire illustrate these fears. Asked about constraints to issuing MREL-eligible debt, 17% cited a lack of investor demand because of the unattractive risk/return profile of bail-in bonds, and a further 17% a lack of demand due to ongoing regulatory and supervisory uncertainty. 

Banks across the EU are struggling to generate enough profits to fill their MREL buffers organically. Payments to bail-in bond holders, which come out of earnings, are exacerbating the problem

In this environment, banks that appear to be shaky and those domiciled in countries ravaged by the sovereign debt crisis may struggle to tempt investors with their MREL-bonds. Understandably so, as MREL holders stand to lose everything if the issuer falls below regulatory capital minimums.

Circumstances aren’t likely to improve, either. Banks across the EU are struggling to generate enough profits to fill their MREL buffers organically. Payments to bail-in bond holders, which come out of earnings, are exacerbating the problem.

Less than 60% of banks surveyed by the EBA generated a return on equity above their cost of equity, while the average return on assets decreased to 0.47% from 0.48% in the year to end-June. If these trends continue, many firms could struggle in future to make ends meet. Investors, alert to this, will become skittish about holding too much of their bail-in debt.

The EBA is urging banks to act now. Roughly one-third of all investment-grade bonds now pay negative yields and investors are hunting everywhere for returns. This has “resulted in a benign funding-market sentiment”, the watchdog says, which those banks with substantial MREL shortfalls should take advantage of.

But will investors’ hunger for yield trump their bail-in jitters? In September, UK lender Metro Bank had to abort the sale of an MREL bond because of investor concerns following a regulatory reporting scandal earlier this year. Weeks later, after giving its chairman, Vernon Hill, the boot, the bank was able to place the bond – but only with a jumbo coupon of 9.5%.

Metro Bank may be an exceptional case, or it may be just the first in a long line of medium-sized banks that will struggle to sell bail-in debt in the months to come.

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