DEALTALK-Convertibles to play role in bank capital scramble

Published 09/29/2010, 08:33 AM
Updated 09/29/2010, 08:36 AM

(For other DEALTALKs, click on

* Alternative route for banks to get equity

* Issuance lull due to low rates, flat equities, low yields

* A tool for governments to exit bank holdings

By Jane Merriman

LONDON, Sept 29 (Reuters) - European banks could turn to convertible bonds to help raise capital required under new regulations to strengthen them against future crises.

Banks that find it tough to access the equity markets directly could tap the investor base that traditionally buys these instruments, which convert to equity after a fixed term.

These investors could include equity income funds looking to boost yields, as well as retail investors, hedge funds and sovereign wealth funds, bankers say.

"For investors, it's a way to get income from the coupon on a bond at a time when banks' dividend yields are low. The investors expect the bond to convert and are happy with the equity risk," said Prasad Gollakota, head of capital solutions at UBS.

Convertibles won't be the first choice for national champion banks, who can more easily tap existing shareholders as Deutsche Bank is doing to raise more than 9 billion euros.

Convertibles upset existing shareholders whose holdings are diluted on conversion. Still, they are an option for firms that urgently need capital unable to find buyers for pure equity.

Some banks, such as Fortis, used convertibles during the credit crisis to shore up capital reserves.

Britain's Barclays Plc raised 1.5 billion pounds by selling mandatory convertible notes (MCNs) two years ago, mostly to Middle East investors, when it was in a rush for cash. The fundraising angered shareholders, however, who were diluted.

When issuance of these bonds rebounded in 2009 after the credit crisis, the issuers were mainly high-risk corporates, from firms without a credit rating or a with a rating below investment grade.

CAPITAL HUNGRY

Bank capital is in demand after global authorities told banks they needed to more than triple the amount they hold to 7 percent, under reforms dubbed "Basel III".

Some banks have already built up extra stores of capital, but others have more to do.

Germany's bank association has said the country's 10 biggest banks may need 105 billion euros under the new Basel rules. Irish, Greek, Portuguese and unlisted Spanish banks could all need additional capital.

But institutional investors have limited appetite for new equity from banks. And on the fixed income side, hybrid Tier 1 bonds that can qualify as capital under the new Basel regime are still in the design phase.

"Multiple solutions are needed," said one senior debt capital markets banker at a European bank.

"We believe some banks will closely look at issuing Tier 1 qualifying mandatory convertibles (as some banks did during the peak of the crisis), as an alternative route to bolster their Tier 1 capital position," said Gollakota. "It could be cheaper for the issuer than pure equity."

This year convertible bond issuance as a whole has been in the doldrums because low interest rates, low volatility in the equity markets and low bond yields have made them less cost-effective.

In Europe, issuance so far this year is about $13.5 billion, compared with about $35 billion for the whole of 2009, according to Thomson Reuters data.

ALTERNATIVE SOLUTION

The traditional convertible bond issuers -- companies hungry for capital such as high-tech or healthcare firms -- are finding high-yield bonds a cheaper option at present.

The drive by regulators to force banks to hold more pure equity capital could spur some issuance from the finance sector.

"Banks have rarely done mandatory convertibles in the past, especially in a public format," said Gollakota. "However, with the change in regulatory definition of Tier 1, and emphasis on quality of capital, these instruments are more relevant going forward."

Convertible bonds could offer a solution for some banks because investors who buy convertibles ultimately want equity.

"Convertibles provide investors with downside protection but they can still participate in the upside," said David Clott, senior fund manager - convertibles at Aviva Investors.

"If some banks were to do mandatory convertibles they would likely be attractive," said Clott. "We have had a few calls to sound us out on banks doing convertibles."

He also said governments might use convertibles or exchangeable bonds as a possible route to reduce their stakes in banks they had to rescue during the crisis. (Editing by Louise Heavens)

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