Santander Gives Bond Investors a Nasty Surprise

(Bloomberg) -- Banco Santander SA reminded investors that juicy bonds can come with nasty surprises.

The Spanish lender rattled the bank Additional Tier 1 market by saying it will skip an option to call 1.5 billion euros ($1.7 billion) of perpetual contingent-convertible notes next month, sending the bonds tumbling. The announcement came late Tuesday, right at the deadline for a decision, after the bank kept investors in the dark for weeks regarding the call option and in the aftermath of another deal, a sale of dollar AT1 notes on Wednesday.

“The handling of the situation was truly disastrous,” said Timothee Pubellier, a portfolio manager at Financiere de LA Cite SAS, which holds Santander CoCos. “Credit investors will need some serious new issue premium to touch that name again."

Santander Gives Bond Investors a Nasty Surprise

The Spanish bank opted against a call due to an “obligation to assess the economics and balance the interests of all investors,” a company spokesman said in an email. “We will continue to monitor the market closely and will seek to exercise call options where we believe it is right to do so,” he said.

The euro AT1s tumbled to 97 cents on the euro following the announcement. The notes traded at almost par last week when the dollar CoCo sale stoked optimism for a call.

The decision to skip the call may drive up costs across the market for the regulatory-driven bank bonds as investors have traditionally priced CoCos in the expectation that they will be called at the first opportunity. It may also tempt other banks to follow suit, presenting a looming market risk as the number of AT1s with low post-extension rates approaching their first call dates will pick up into next year.

“This is very surprising and it is a really bad news for CoCos, specially for those that have low coupon for the first call,” said Alfonso Benito, chief investment officer at Spanish asset manager Dunas Capital. “The market is going to request additional premium for this kind of product in the future.”

Read more: Barclays, Santander Lead EU15b of CoCos Approaching First Calls

The yield to maturity on the euro AT1s widened to 5.7 percent after the non-call announcement. The bank’s dollar AT1s with a May call option slipped to 97.8 cents. Its American depositary receipts traded slightly higher in New York, climbing 0.7 percent to $4.55.

Skipping the call may work out cheaper for Santander than redeeming the notes and selling new ones because the floating rate after extending the existing notes is lower than current market-funding costs. Against that, the bank had to weigh potential reputational damage that could drive up borrowing costs across its future subordinated issuance. Other banks will have to make similar calculations in the months ahead.

Banks have rarely broken with convention on calling subordinated notes at the first opportunity. Deutsche Bank AG roiled credit markets in 2008 when it skipped a call option, triggering investor losses. Assumptions were shaken again in 2016 when Standard Chartered Plc and German lender Commerzbank AG extended similar notes.

Market Maturing

For some, the decision had merits. Redemption is voluntary and regulators gave banks no extra incentive to call the notes as they didn’t include a guaranteed coupon step-up in the design of the notes.

This is a “sign of the market maturing,” said Steve Hussey, head of financials research at AllianceBernstein Holding LP. “This is what banks are supposed to do. It should be an economic call decision, not reputational.”

AT1s are the riskiest form of bank debt, as the notes can be written off or converted into equity if a lender’s capital level drops too low. Lenders can also skip coupon payments without triggering a default. These risks for investors are offset by high coupons that have let euro investors post total returns of 3.9 percent on CoCos over the past year, according to Bloomberg Barclays index data. That compares with just 0.5 percent for senior euro bank notes.

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