(Bloomberg) -- Investor confidence in Iceland’s banking system is about to face a new kind of test.

Two years ago Arion Bank hf became the first Icelandic bank to return to the stock market since the financial crisis, during which time the country’s three-largest lenders collapsed and plunged the economy into financial ruin.

Now the lender, created from the remnants of Kaupthing, is poised to lead the Nordic country’s banks into the riskiest corner of the bank debt market too.

On Friday Arion Bank began marketing Iceland’s first ever additional tier 1 notes, a perpetual security that forces losses on a bondholder if the bank fails. The U.S. dollar offering “has significance as it will give some intel on investors’ attitude toward the most equity-like debt instruments from Icelandic banks,” Nicolai Pertou Ringkobing, an analyst at Danske Bank A/S said.

The AT1 deal also comes amid a global slump in bond yields that has fired demand for once-seemingly unsellable debt. Greek banks are routinely issuing subordinated notes as memories of the nation’s own financial crisis fades. And this week the troubled lender Deutsche Bank AG was flooded with $14 billion of orders for its first AT1 sale since 2014.

Yield Hunger Sets Stage for String of Landmark Bank Bond Sales

Optimal Capital

The AT1 notes will aim to strengthen Arion Bank’s already ample capital position by “creating room for additional distributions” and to optimize the lender’s capital structure, Theodor Fridbertsson, Arion Bank’s head of investor relations, said by phone.

The bond documentation contains a trigger that would lead the bank’s notes to convert into shares if its CET1 ratio falls to 5.125%, according to a report by Standard & Poor’s Global Ratings, which rates the notes BB. Arion Bank’s CET1 ratio stood at 21.2% in December, the rating firm said.

Arion Bank said in its fourth-quarter report that it’s vital to reduce core equity to achieve a target of 10% return on equity. AT1 and Tier 2 bond sales will allow the lender to use capital more efficiently with equity seen as “the most expensive source of funding,” the report noted.

Iceland’s government is also lending a hand with a legislative bill to remove restrictions on making interest payments on the securities tax deductible, according to Fridbertsson. “We have not issued AT1 debt because the coupon payments have not been deductible.”

Following a recent run of successful subordinated debt sales from other European banks, “it’s a decent time to come to the market,” Danske’s Ringkobing said. However, “the bond will have to offer an attractive spread.”

--With assistance from Neil Denslow.

To contact the reporter on this story: Leo Laikola in Helsinki at llaikola@bloomberg.net

To contact the editors responsible for this story: Kati Pohjanpalo at kpohjanpalo@bloomberg.net, Charles Daly

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