* Ukrainian crisis underlined risks in banks' bond drive
* Banks issuing bonds to boost defences against potentiallosses
* Bankers still expect 2014 to be a record year for suchbonds
By Steve Slater and Aimee Donnellan
LONDON, March 25 (Reuters/IFR) - European banks such asSociete Generale, Credit Agricole and Unicredit will likely haveto pay investors a higher return to buy the risky bonds thatbanks use to strengthen their balance sheets after the crisis inUkraine forces a rethink about the potential dangers from suchinvestments.
So far this year, European banks have sold over 7.5 billioneuros of bonds to boost their core financial strength andbankers expect that tally to reach a record 40 billion euros for2014 as mainstream investors such as insurers and pension funds,who need to boost returns, buy more of them.
But KBC Bank's sale of 1.4 billion euros worth ofsuch bonds at an interest rate of 5.625 percent, the lowest everoffered despite the Belgian bank's chequered past, could markthe end of the sweet spot for banks hoping to sell such debt atrock bottom rates.
The KBC paper, issued two weeks ago, has dropped over 2percentage points in the secondary market as a standoff betweenRussia and the West over Ukraine has increased volatility acrossfinancial markets and alarmed investors who fear banks couldsuffer disproportionately.
When volatility strikes markets, these so-called AdditionalTier 1 (AT1) bonds are among the first to sell-off because theyare riskier investments. When a bank gets into trouble its AT 1bonds usually either convert into bank shares or are temporarilywiped out.
"We are confident that banks like KBC are well on the roadto recovery but the coupons that are on offer are not reflectingthe risk profile of the instruments," said Satish Pulle, leadportfolio manager at ECM, a fixed income house that has around$8.2 billion of assets under management.
"We need to be demanding more yield to protect ourselvesfrom volatility."
Investors offered 7 billion euros worth of orders for theKBC issue, enabling the bank, which had to be bailed out byBelgium during the financial crisis, to offer a rate 2percentage points lower than similar issues just a few monthsearlier.
On a 1 billion euro issue, a bank would pay 10 million eurosa year for each extra percentage point of interest it pays.
Banks are pricing these bonds cheaply and investors are nowreassessing the credit risk.
"These are really risky instruments with complicatedstructures and not every bank that has issued them is in a greatposition," said one banker who specialises in such debt.
CONGESTION
Europe's banks are expected to issue up to 240 billion eurosof AT1 bonds in the next five years after regulators said theycan hold AT1 bonds equivalent to 1.5 percent of their assets.The bonds are cheaper to issue than shares, which are also usedto strengthen banks' balance sheets.
"Given the amount of potential supply over the next fewyears there's clearly the possibility for markets to getcongested from time to time," said Simon McGeary, managingdirector for new products at Citigroup in London.
"The last few weeks has really been the first test of thatwith several deals in the market simultaneously."
The potential market could be swelled even further ifregulators force banks to increase their leverage ratios, whichcould spur the likes of Deutsche Bank or Barclays to bump up their issuance.
The aim is to create an extra layer of protection to preventa repeat of the 2007-2009 financial crisis when taxpayers borethe brunt of bank bailouts.
About 35 billion euros of AT1 bonds have been issued sincethe financial crisis. This week, French banks Societe Generale and Credit Agricole said they planned moresales and Italy's UniCredit started a roadshow forinvestors on Monday and is expected to raise about 2 billioneuros from an issue.
HSBC, Deutsche Bank, Barclays, Commerzbank and Nordic lenders also all seem poised to follow andsells billions of euros worth.
The bonds have commonly paid interest of 6-9 percent, anattractive rate given central banks have kept rates close tozero. But that higher interest rate reflects a risk thatinvestors could lose their money, or end up owning shares theymay not want.
To avoid retail investors getting stung by such exposure,the regulator in Britain has made it clear it does not want suchbonds sold to them. Two deals this year from Nationwide andLloyds were structured to keep small investors away.
Sweden's regulator could also dampen demand for such bondsif it sets the "trigger" at which the bonds convert into sharesor are wiped out at a very high rate, making it more likelyinvestors will be hit.
Bankers said Stockholm could decide that AT1 bonds convertinto shares in a bank or are temporarily wiped out when themoney that the bank has set aside to cover potential futurelosses shrinks to 10 percent of its risk weighted assetscompared to 7 percent in most countries. (Additional reporting by Helene Durand at IFR. Editing byCarmel Crimmins and Giles Elgood)