The stagnant additional Tier 1 capital market needed a shot in the arm after a string of disappointing issues in 2014. Enter HSBC and its inaugural AT1 issue.

As autumn arrived in Europe this year, the leaves also seemed to be turning brown in the once verdant market for contingent convertibles (CoCos). Something special was needed to reinvigorate it, and that something duly arrived – HSBC’s $5.7bn inaugural additional Tier 1 (AT1) issue, the largest of its kind so far.

The EU version of Basel III’s rules on capital adequacy came into force at the start of 2014. Since they prescribe minimum levels of loss-absorbing capital, this has been the year of the CoCo. Financial institution group (FIG) hybrid issuance in Europe, the Middle East and Africa (EMEA) during the first half of the year was brisk, with AT1 issues from banks including Crédit Agricole, BBVA, Santander, Société Générale and, once Germany had belatedly clarified the tax position, Deutsche Bank. Most were in considerable size and all were mobbed by yield-hungry investors.

Santander’s first AT1 in March, which raised €1.5bn, drew orders of €17bn, for example. But then the implosion of Portugal's Banco Espírito Santo in June gave investors a reality check when holders of its Tier 2 bonds found themselves in the 'bad' bank. There is a reason why subordinated debt yields are generous.

Bank hybrid traded down and the ensuing silence was broken only in September, when Santander launched its third AT1 deal of the year, another €1.5bn transaction. It drew orders of only €3bn and performed badly in the secondary market. UniCredit followed almost immediately with another AT1 and had to increase the coupon to get the issue away safely.

A knight in shining armour

It was a market that needed rescuing. And then along came the cavalry, in the shape of HSBC and its long-awaited AT1 transaction. HSBC had last issued Tier 1 securities in 2010, when it sold $3.8bn in preference shares in the largest ever such deal from a non-US bank. It had not rushed to market with its first AT1 issue but absorbed what other early issuers, notably UK banks, had done.

The Capital Requirements Directive IV, the new European rule book on bank capital, allows banks to raise up to 1.5% of their risk-weighted assets (RWAs) as AT1. They could fill this space with common equity tier 1 (CET1), but that is more expensive. HSBC has RWAs of some $1200bn so, with a buffer for redemptions of old-style Tier 1 capital, it needs about $19bn of AT1.

The key choices most AT1 issuers must make are the nature of the loss-absorption mechanism, and the point at which loss absorption will be triggered. European AT1 bonds may be converted into equity, suffer a temporary write-down or a permanent write-down. As a UK bank, HSBC does not have the option of temporary write-down since the UK’s Prudential Regulation Authority (PRA) does not approve of them. It feels the same way about low triggers so, while most European banks have chosen a 5.125% trigger level, HSBC was left with the Hobson’s choice of 7%.

Pulling the trigger

“Investors dislike triggers, and they have a greater aversion to high triggers, but latterly they have recognised that their primary risk relates to potential coupon loss,” says Alain Stangroome, HSBC’s head of group capital planning. Investors have come round to being less focused on the absolute level of the conversion trigger and more so on the buffer to it.

“We felt that, taking into account the balance of risk and reward to our investors, a write-down in full at the 7% trigger was not right,” says Mr Stangroome. “So equity conversion was the only game in town.”

The strike price for the conversion was set as the lowest share price over the past 10 years. “This was a key positive,” says Adam Bothamley, head of EMEA debt syndicate at HSBC. ‘The strike price in some other deals has been based on a discount to the share price on the day, but that means different tranches have different strike prices.” The 10-year low stipulation means that future securities can all use the same conversion price.

Other choices involved currency, size and split. Getting the balance right for the first transaction was important. Pricing needed to be as tight as possible, as a reference point for future issues. But a healthy oversubscription was also desirable, to encourage demand for future issuance.

The multi-billion dollar question

The decision to issue in dollars and euros was logical enough. HSBC is essentially a dollar bank. It reports in dollars and two-thirds of its balance sheet is weighted towards that currency.

“There is a deeper universe of dollar buyers for these instruments,” says Christoph Hittmair, global head of FIG debt capital markets (DCM). Asia, a second home market to HSBC, also favours dollar assets, while a euro tranche would cater to expected demand from European and Swiss accounts.

Mr Stangroome’s key instruction to DCM was that this should be perceived to be a good transaction. “I wanted it to be good on pricing, good from an investor perspective – which meant trading well afterwards – and good for all other parties, to facilitate potential repeat transactions,” he says.

Not unusually, HSBC went for two separate call dates in dollars. A perpetual non-call 10-year tranche was designed to appeal to big US investors, while the Asian market and multicurrency asset managers are more inclined towards the non-call five-year tranche. The euro tranche split the difference with a non-call eight-year structure. At the outset, the bank was reasonably flexible on size, and inclined to be guided by demand, though it was counting on at least $1bn equivalent for each tranche.

There was no sterling issue. It was felt that three tranches was the right number to create optimum pricing tension. Feedback suggested that there was more capacity in euros than in sterling, which had become more volatile as a 'yes' vote in the impending referendum on Scottish independence seemed increasingly possible.

Coming to market

Stock exchange waivers and shareholder approval for the equity conversion were in the bag by May, and it was only then that legal preparations could start in earnest. August and the summer break then intervened, so it was September before the transaction could come to market, with HSBC as sole bookrunner.

Conditions were not exactly perfect. AT1 prices had dropped over the summer. The Santander and UniCredit AT1 issues had stumbled and there were questions over how deep this market really was. To compound matters, Bank of America Merrill Lynch removed all CoCos from its corporate bond indices. “This deal became the most important thing for the AT1 market at the time,” recalls Mr Bothamley. “It needed to go well to restore investor confidence.”

Three teams carried out roadshows in Asia, the US, London and continental Europe, with the chief financial officer present in the London meetings. The story emphasised HSBC’s strong capital and earnings generation. “In the AT1 space investors are looking at how issuers treat bondholders, and their standing and track record,” Mr Bothamley maintains. “The perception of HSBC is that it has done and will continue to do right by its bondholders.”

One reason that the deal attracted such widespread interest was that it was the first investment-grade AT1 transaction to date, and so catered to a larger investor universe. The order books swelled to a mammoth $30bn equivalent and the deal was priced at the tight end of guidance. The final make-up was €1.5bn non-call eight-year tranche at 5.25%, a $1.5bn non-call long five-year tranche at 5.625% and a $2.25bn non-call 10-year tranche at 6.375%. These were the lowest coupons for a high-trigger AT1. Perhaps most important of all, the bonds traded up.

“The good thing about the transaction was that it did perform well, but not by so much that it could be accused of being cheap,” says Mr Hittmair.

The market has since dipped on general global growth, geopolitical tension and ebola jitters, but at the time the HSBC deal gave it the shot in the arm it so badly needed. HSBC will inevitably be back in the AT1 market, though not this year. “We will tend to issue $6bn to $8bn of non-core capital each year, in windows based around our results,” says Mr Stangroome.


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