CCDS Should Escape Payout Suspensions

With central banks and governments pumping huge amounts of funding into their domestic economies, they are obviously very keen that companies act with prudence and look after their surplus cash sparingly, by cutting back on distributions such as dividend payments and any share buyback plans.

This issue has been put in the spotlight by Easyjet’s recent decision to go ahead with a £174m dividend, while at the same time saying it would need government assistance to cope with the COVID-19 crisis. Unsurprisingly, the government has quickly poured cold water on any talk of aid for the airline.

The Bank of England and European Central Bank have both spoken about how their banking systems are now in great health, and can be part of the solution in mitigating the global slowdown; both have also announced strong supportive measures including the release of counter-cyclical buffer capital to help increase the potential capacity of bank lending.

However, at the same time they are keen that banks do not take this opportunity to reward equity holders at a time when profitability is likely to be negatively impacted. Indeed, it was no surprise to see the ECB release a statement on Friday evening recommending that no dividends should be paid out by credit institutions until “at least” October 1, 2020, no “irrevocable commitment to pay out dividends” should be made for the 2019 and 2020 financial years, and they should also refrain from share buybacks “aimed at remunerating shareholders”.

Unsurprisingly, the ECB did not make any recommendation on debt instruments and we would not expect coupons to be impacted, though some banks have still decided to explicitly confirm that coupons will be paid on all debt, including Additional Tier 1 (AT1), in press releases announcing dividend suspensions.

One bank that did surprise markets was Rabobank, with its decision to suspend distributions on its 6.5% perpetual Member Certificates (MCs). The Dutch lender is a mutual, and its MCs together with its retained earnings represent part of its common equity tier 1 (CET1) capital. With no outstanding common shares, Rabo has decided to “use its discretion not to pay any distributions on its CET1 instrument, the Rabobank Certificates, on the upcoming scheduled payment dates of 29 March, 29 June and 29 September 2020”, after which it said it would review the decision, “which could result in no, lower or higher payments being made”.

Rabobank is obviously being very conservative, and while its MCs count as CET1, and rank below its AT1s, they are widely seen as a debt instrument, being traded by fixed income rather than equity desks and being broadly held across fixed income funds. One unintended consequence of this for Rabobank could be that fixed income managers begin viewing MCs as being closer to equity than debt, which would call into question whether bond funds are still happy to hold them. Following the move, the instruments are unsurprisingly trading lower, having given up their gains from last week and settling around the lows of the previous week.

The obvious read across for our readers will be to the Nationwide Building Society’s Core Capital Deferred Shares (CCDS), a product that is also traded by fixed income desks and is considered to be closer to debt than equity. While these CCDS also rank below Nationwide’s AT1s, and the coupons are flexible and based on profitability, they are capped and hence switching them off even on a temporary basis means that unlike normal bank equity holders, CCDS holders cannot have missed payments made up at a later date.

In addition, the CCDS give Nationwide important access to capital markets, and the lender will likely be very sensitive to its members (many of whom are significant holders of the CCDS) being penalised. Nationwide has also highlighted to us that it has only ever tapped the CCDS issue during periods of strength in the markets, and not at stressed valuations in the manner of many banks that were short of capital during and after the global financial crisis. At the last reporting date Nationwide had a CET1 ratio of 31.5%, and passed all of the BoE’s most severe stress tests with full distributions on the CCDS still being met.

So are we expecting a similar recommendation from the BoE regarding banking sector dividends and buybacks? Yes. Will it go further and try to target CCDS too? We don’t think so. It would appear illogical to us for the BoE to penalise one of the strongest (and more prudent) financial institutions in Europe and in doing so, ignore the results of its own stress tests; what then would be the point of having them?

We expect to have a definite announcement from either Nationwide or the BoE by the end of trading on Tuesday. However, in our view the BoE has been the quickest and most decisive of the central banks in dealing with the economic impact of the coronavirus thus far, and we do not expect it to make the mistake of targeting CCDS distributions.