Santander's landmark decision to not pay off a bond could have a major impact on the $140 billion market for risky bank debt

Drew Angerer/Getty ImagesSantander ambushed the bond market by refusing to honour a gentleman’s agreement.
  • Santander’s decision not to “call” (or repay) one of its bonds has confounded investors.
  • Everyone expected the €1.5 billion “CoCo” bond would be repaid under a “gentleman’s agreement.” Santander’s decision not to makes the rest of the €125 billion ($US141 billion) market look a lot more risky.
  • “The fact that a strong global bank has brought such attention to the debt class does not bode well for the multitude of small and weaker institutions that are either already in the market or are thinking of entering the higher-risk junior subordinated market,” said Tom Kinmouth, an analyst at ABN Amro, in a note to clients.
  • Santander seems to be betting that the strength of its business is greater than the damage to its reputation as a reliable participant in the CoCo bond market.

Banco Santander’s decision not to repay one of its capital bonds has stunned investors by suggesting that the €125 billion ($US141 billion) market for European bank debt is a lot riskier than everyone thought.

Investors had expected the Spanish bank to “call” or repay a €1.5 billion ($US1.7 billion) bond on Tuesday to honour an unenforceable “gentleman’s agreement” that such instruments be repaid at the earliest possible opportunity. The “additional tier 1” (AT1) funding is also known as a “contingent convertible” bond, or a “CoCo bond”. It has a “perpetual maturity,” meaning it never needs to be repaid, and it does not count towards equity in the bank’s capital structure.

Generally, banks pay back such bonds in order to maintain their good reputations. Investors are willing to lend money in these bond deals – even though there is no strict obligation for the bank to pay it back – because they get a higher rate of interest payments, compensating them for the greater risk. CoCos are risky as the bonds can be written off or converted into equity if a lender’s capital level drops too low. Similarly, lenders can skip coupon payments without triggering a default.

“Just before the announcement there was incredible tension in the market as the security dropped,” Tom Kinmouth, a fixed-income strategist at ABN Amro, told clients. “The delay in announcing the call had been unusual. Banco Santander waited until the very last day possible before announcing the non-call today.”

“We felt that Banco Santander would call these instruments primarily due to the increase of the cost of the other subordinated bonds that the bank has outstanding. This will come as a negative surprise to the market,” he wrote.

So Santander’s decision to not repay the bond has done three things:

  • It has muddied Santander’s reputation as a reliable partner among bond investors.
  • Conversely, it has showed that Santander is strong enough to get away with such a manoeuvre.
  • And it has made these bonds more expensive for all other banks because investors now know that banks can renege on their gentlemen’s agreements – and they will demand higher interest payments to risk their money with them in the future, according to Kinmouth.

The price of the bond will continue to wax and wane on the market, and investors will continue to get interest payments (a bit like dividends) – but they cannot now force Santander to redeem to bond’s face value. Their investment suddenly and unexpectedly looks much more like a stock, in other words.

AT1/CoCos were introduced by European regulators in the wake of the financial crisis in 2008 in an attempt to improve banks’ capital ratios without the need to raise additional equity. It’s a largely untested part of the European bank market.Deutsche Bank refused to call a CoCo bond once, a decade ago.

“The bank is a strong globally-systemic institution which has experienced incredibly consistent returns. The fact that a strong global bank has brought such attention to the debt class does not bode well for the multitude of small and weaker institutions that are either already in the market or are thinking of entering the higher-risk junior subordinated market,” ABN’s Kinmouth told clients.

Investors had been expecting that Santander would repay the bond after the bank raised another AT1 (a €1.2 billion issuance) last week, and the older €1.5 billion bond rapidly increased in value on the hope it would be repaid. The bond has subsequently plummeted in value as enraged investors sell it.

A Santander spokesperson said, “When making call judgments we have an obligation to assess the economics and balance the interests of all investors. We will continue to monitor the market closely and will seek to exercise call options where we believe it is right to do so.”

Santander’s decision not to pay the bond back at this particular point means the debt switches to a lower interest rate which is variable rather than fixed. That will allow the bank to pay an effectively lower interest rate on the debt, 5.5%, than it would by issuing new bonds.

Despite the call decision Santander’s AT1s rose more than 0.5 cents on the euro to about 98 cents on Wednesday, after tumbling late Tuesday in the wake of Santander’s decision to not use a March redemption option, according to Bloomberg.

So, cheaper for the bank but expensive for investors who bet the call would be honoured.

And after all the complications the whole business can be summed up neatly in this tweet:

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