Europe's banks, under pressure from regulators to bolster their capital, are resorting to buying back their own bonds on the cheap, risking an investor backlash if they try to squeeze bondholders too hard.
Under these so called liability management exercises (LME), banks offer to buy back or swap their bonds at a premium to the market price but a discount to par value. If a bank's bonds are trading at 60 cents in the euro, for example, it can pay 70 cents, giving a premium to the investor and making a capital gain of 30 percent.
More than a dozen banks have announced such offers in the last month, potentially contributing over 8 billion euros (6.88 billion pounds) to their capital rebuilding effort, including Santander
In principle, both sides of the deal should be satisfied. Investors cut the losses on bonds they are holding, while banks book a capital gain and clean up their balance sheet by buying back and cancelling hybrid capital that will not qualify as core capital under new global rules.
But such deals risk angering debt investors if they regard the terms as too stingy, as Santander found out when there was a huge backlash to its offer three weeks ago.
From an equity perspective it's good, from a bank capital perspective it's good, but it's not always a good event for the bond investor. It can be, but it's not always, said Chris Bowie, head of credit portfolio management at Ignis Asset Management, which invests 40 billion pounds in fixed income.
Less than a quarter of investors signed up to swap up to 6.8 billion euros of Santander's subordinated bonds into new senior debt, unhappy at the slim premium and low interest rate on the new bonds and the prospect of getting stuck with illiquid bonds. Santander also signalled it will not 'call' the bonds early, or repay them before they mature, as is typical.
A lot of bond investors were very upset by this. They (Santander) have tarnished their reputation for any future funding they want to do, said Ignis's Bowie, adding it was likely to increase the future cost of funding for Santander.
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Offers by Barclays and others since have been regarded as more investor friendly, though each has to be judged on its own merits, investors and analysts said.
Barclays is offering to buy back up to 2.5 billion pounds of its bonds, and could make a gain of more than 500 million pounds if the offer is fully taken up, according to Reuters calculations, and potentially more from other hybrid capital it holds.
Other big names to launch liability management exercises in recent weeks include UniCredit
More are likely to follow, possibly Royal Bank of Scotland
The flurry of activity, reminiscent of a wave of offers in 2008, has been sparked by depressed bond prices, a minimum core capital requirement of 9 percent, and stricter rules on what qualifies as core capital.
The process is helping banks meet a capital shortfall, which the European Banking Authority (EBA) estimated at 106 billion euros and said must be filled by mid-2012.
It's a start, but it's not going to be the solution (to all capital needs), said Chris Wheeler, analyst at Mediobanca.
Across Europe you'll see more of these activities as part of the EBA exercise of meeting capital, he said, adding they were also attractive for banks holding hybrid debt that would no longer qualify under Basel III rules as core capital.
UK banks have further incentive to act as they will need to hold debt that can be bailed in -- where bondholders will have to share the burden of bailing out a bank -- and are cleaning up their balance sheets in preparation for that.
Barclays Capital analysts estimated that 14 of the euro zone's biggest banks alone could raise 14.6 billion euros from liability management.
The trend may please regulators as well as banks. It improves the amount and quality of capital held, but not at the expense of cutting loans that could damage economic recovery.
Some investors such as hedge funds are keen, too, as they can buy bonds at a depressed price in the hope of making a quick profit on an LME. But it can be a risky business.
Recent skinny LME premiums with the alternative of remaining in a far less liquid rump, together with high volatility which can wipe out premiums in a day, suggests that the 'chasing LMEs' trade is a brave one, said Jackie Ineke, bond analyst at Morgan Stanley.
(Additional reporting by Helene Durrand at IFR; Editing by Will Waterman)