There have been several further market successes this week, notably the strong response to Uzbekistan's debut dollar bond sale, which was expanded to involve both five and ten-year reference tranches and attracted at least USD6 billion of demand (some sources have suggested over USD 8 billion). Uzbekistan was accompanied by issuance by Turkey, Indonesia, Latvia and Credit Bank of Moscow, along with over USD50 billion of demand for a USD11.5 billion acquisition package by tobacco producer Altria.

However, this week's most interesting development was on 12 February, when Banco Santander became the first bank not to call an Additional Tier 1 (AT1) perpetual contingent-capital deal at its first call date. The EUR1.5 billion issue was sold initially in March 2014, with a 6.25% coupon for the first five years, with the first call date on 12 March 2019. After this, the issue's coupon adjusts to 541 basis points over the five-year mid-swap rate until subsequent quarterly call dates. In the current market environment, this equated to an initial new rate of 5.54%. Santander has a further USD1.5 billion of AT1 debt with a 6.375% coupon due for first call on 19 May, with a post-call coupon of 488 basis points over dollar five-year mid-swaps.

A bank spokesperson explained that in deciding whether or not to call a bond, the bank had the obligation to "evaluate the price" of refinancing and to "balance the interests of all its investors", considering the desire of shareholders to minimize its interest costs as well as the expectation of bondholders to be called despite the formal perpetual maturity of the instruments in question. The bank will "continue to monitor the market closely" and "will seek to exercise call options when we believe it is right to do so".

Similar issues have arisen previously in the market for dated subordinated debt. In 2008, Deutsche Bank elected not to call a Tier 2 bond, with Commerzbank and Standard Chartered taking a similar stance in 2016. However, these are isolated events. The standard market practice is to redeem subordinated and contingent-capital deals at first call despite their longer or perpetual formal maturities.

Our Take

Santander's decision not to call its AT1 deal had been discussed repeatedly by bank representatives in recent months. They had made clear that due balance needed to be established between the interests of AT1 noteholders and the bank's shareholders. At the bank's recent results presentation, General Manager José Antonio Álvarez spelled out that Santander would make its decision based on "strictly economic terms".

Santander's stance appears economically rational, in that the cost of refinancing its outstanding AT1 deal would have been greater than the floating rate interest rate now payable until the next call date. However, its stance increases the perceived riskiness of AT1 issues, with investors now having less certainty over their likely maturities, potentially reducing demand for such securities and increasing bank borrowing costs for capital instruments. Initial market fallout appears modest: the instrument affected fell some two percentage points in price, from 99% to 96.75%%, having been as low as 94% in January. Subsequently, Svenska Handelsbank appointed banks to arrange a dollar AT1 deal in the near future.

Overall, there is an obvious logic behind the bank's decision. Santander is a strong and profitable firm: while subject to some market scrutiny given its sizeable UK exposures and its need to strengthen capital and TLAC ratios over time, there is nothing to suggest it was forced to avoid call due to inability to access markets (as proven last week) or by financial stress. The market norm of assuming early redemption is somewhat illogical and is likely to become more so in an environment of rising interest rates.

Overall, Santander has set an interesting precedent. Future developments in the bank capital sector will be indicated by whether more banks follow its example, and it elects not to call further issues, or whether it backs down and redeems the issue at the next or subsequent call date. A key indicator will the degree of damage to its borrowing costs for future issuance: if these rise sharply, the bank and others may yet find that early call proves a rational choice for shareholders as well.

More broadly, Santander's move is an adverse indicator for likely issuance costs in the AT1 sector, and may well reduce demand. However, it would also be a sign of greater market maturity for investors to purchase such instruments based on their formal defined risk characteristics, rather than relying on an assumed "informal arrangement" whereby early call is the established norm irrespective of the actual cost of refinancing.

Separately, Uzbekistan's dollar debut has been clear success. The deal garnered "very strong early interest", going on to attract a very sizeable order book, and its two-tranche configuration clearly went beyond the initial plan to undertake a single benchmark sale. Uzbekistan has suggested that it is likely to return to the markets and that its sovereign debut will be the precursor to issuance by other borrowers from the country. Potential follow-on issuers mentioned include Uzbek Industrial and Construction bank, Asaka, Ipoteka Bank and National Bank of Uzbekistan, along with state energy firm Uzbekneftegaz.

Posted 15 February 2019 by Brian Lawson, Senior Economic and Financial Consultant, Country Risk, S&P Global Market Intelligence