Mizuho Financial Group Inc. and Sumitomo Mitsui Financial Group Inc. plan to bolster their balance sheets by introducing bonds that offer investors enhanced returns at greater risk.

The two banks will sell so-called Tier 1 notes, or instruments whose value may be written down if the issuer’s capital falls below a specific level. The debt will be sold as early as this month, their units said last week, part of a trend that could see the local market for such securities expand to as much as ¥4 trillion ($32 billion) by 2019, when tougher Basel III banking rules come into full effect, according to Daiwa Securities Group Inc.

Mitsubishi UFJ Financial Group Inc. sold the nation’s first batch of these bonds in March. The draw for investors is the fat coupon. The subordinated debt issued in March had a yield of 2.7 percent, almost five times the rate on senior notes from the group maturing in 2024.

“These bonds are at the frontline for protecting banks,” said Toshiyasu Ohashi, the chief credit analyst in Tokyo at Daiwa, the nation’s No. 2 brokerage.

“The securities offer attractive yields but whether they are sufficient to meet the risks, on that there are differing views.”

Global lenders, including HSBC Holdings Plc and Deutsche Bank AG, have already sold $180 billion of the notes devised by regulators to shift the burden of bank failures from taxpayers to investors. The expansion of Japan’s biggest banks overseas is increasing their risk assets and placing more demands on their capital.

Japan’s mega-banks will likely continue selling the Tier 1 bonds as securities they issued to comply with previous Basel banking rules become ineligible, according to David Marshall, a credit analyst at CreditSights Inc. in Singapore. The outstanding amount of such instruments at the end of March 2013 was ¥6 trillion, according to Daiwa calculations.

“They all have a long way to go in terms of issuing more Basel III” compliant Tier 1 bonds, Marshall said. “The key feature of the Basel III capital instruments is that they should be able to absorb losses even if the banks are not in bankruptcy.”

A 14 percent drop in the yen versus the dollar helped Mitsubishi UFJ, Japan’s largest bank with the biggest presence in the U.S., report a record profit in the fiscal year ended March 31. The currency move also weighed on its capital level while Sumitomo Mitsui and Mizuho saw their capital ratios increase.

Net income at Mitsubishi UFJ rose to ¥1.03 trillion, while the bank’s common equity Tier 1 ratio, an indicator of financial strength, fell 11 basis points to 11.14 percent. Its risk assets climbed 13 percent to ¥111.9 trillion.

“If the major banking groups carry out more mergers and acquisitions or increase overseas lending, their risk assets may rise sharply and disrupt their pace of accumulating capital,” Standard & Poor’s said in May. “We view this as a risk factor.”

Mizuho Financial, Japan’s third-biggest bank by market value, will offer perpetual subordinated bonds as early as this month, Mizuho Securities Co. said June 24. SMBC Nikko Securities Inc. said Sumitomo Mitsui, the nation’s No. 2 lender, plans to sell in the second half of this month.

Mitsubishi UFJ issued ¥100 billion in notes in March that may be written down if its common equity Tier 1 capital ratio falls below 5.125 percent, according to a statement by the Tokyo-based bank. The perpetual bonds are callable after July 15, 2020.

Mizuho and Sumitomo Mitsui have already sold Tier 2 Basel III notes in yen and dollars that are considered less risky for investors because the trigger for writedowns is when regulators deem the issuer at risk of becoming not viable.

With the increasing weight of dollar-denominated loans held by Japan’s mega-banks, it makes sense for them to sell Tier 1 Basel bonds in the U.S. currency, too, to match overseas growth, CreditSights’s Marshall said .

“There is a mismatch,” he said. “Those loans are in dollars predominantly, while their capital is in yen.”

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