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Santander’s shock bond move is controversial but not contagious, analysts say

February 22, 2019

Pedestrians pass by a Santander Bank branch in New York.

Scott Mlyn | CNBC
Pedestrians pass by a Santander Bank branch in New York.

Santander’s decision to not repay investors on a special type of bond this week may have surprised investors, but analysts have told CNBC that any fears of financial stress in the market are unfounded.

The Spanish bank’s 1.5 billion euro ($1.7 billion) contingent convertible bond, or CoCo bond, was eligible for early repayment which is usually exercised in the financial world. But the bank on Tuesday decided against giving investors their cash back citing an “obligation to assess the economics and balance the interests of all investors.” The bank said it would only pay back on these bonds when it believes “it is right to do so.”

What is a CoCo bond?

These bonds are slightly riskier than a normal corporate bond as they convert into equity when the buffer levels of a bank fall below a certain ratio. Thus they make the holder lose cash in times of financial stress but can help keep a bank steady at the same time.

In the aftermath of the 2008 financial crisis, the Bank of International Settlements — known as the central bank of central banks — made it necessary for banks to hold CoCo bonds, which are officially called additional tier 1 (AT1) capital. They have what’s known as a “perpetual maturity.” This means that they don’t have to be repaid but they come with a call option — or an option for the issuer to repay the investor before the end of the maturity date.

Banks generally exercise this option to send a message to the markets that their liquidity position is strong enough to deal with a crisis situation. Santander’s decision this week may have brought back memories of when Deutsche Bank decided not to call a CoCo during the 2008 crash.

According to data from research firm Refinitiv, about $13.5 billion worth of CoCos are redeemable this year. Of this, $8.4 billion are from European banks.

Frankfurt's skyline as viewed from the top floor of the new European Central Bank headquarters.

Ralph Orlowski | Getty Images
Frankfurt’s skyline as viewed from the top floor of the new European Central Bank headquarters.

‘Santander is not stupid’

Santander’s decision this week has left debt investors with a dilemma. They have started to question whether this is the start of many “missed calls” and whether other banks will follow suit.

“Not necessarily the first of many ‘missed calls,’ but surely it is a deep break from the past in the treatment of an instrument that is based on a non-binding gentleman’s agreement and has never successfully been utilized for what it’s been designed for by regulators: precautionary recapitalization,” Francesco Filia, the CEO of Fasanara Capital told CNBC via email on Wednesday.

While it’s optional for the issuer to call the bond, investors in the market generally rely on this and are forced to recalibrate their options in case of a fail. Bill Blain, a strategist at Shard Capital, explained in a research note why this isn’t necessarily a worrying move.

“Santander is not stupid. It proved itself good at acquisitions … Now it’s showing pragmatic credentials,”

Market commentators believe the decision to not exercise the call option may be cost-effective for Santander in the long run.

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“The non-called deal currently yields 6.25 percent but will switch to a lower floating rate around 5.50 percent after the call expires. That means it’s costing them less than refinancing,” Blain said.

Meaning the interest for the bond after this extension will be less than issuing a new CoCo bond in the market. Earlier this month, Santander issued a new $1.2 billion AT1 note to a group of what’s believed to have been mostly European investors.

Furthermore, when the bank fails to exercise a call option, the value of the bond in the market drops as investors start to question the health of the issuer. However, in this case it could also be due to Santander’s lack of clarity on what it was doing. The value of Santander’s bond fell sharply following the decision but pared some losses on Wednesday morning.


Categories: Bonds