By Valentina Za and Francesco Canepa

MILAN (Reuters) -UniCredit is leaning towards repaying a perpetual bond at the earliest opportunity in June, a source close to the matter told Reuters, a move that would show it has ample capital and help keep funding costs in check as markets reel from a crisis of confidence.

UniCredit put in a request in recent weeks with European Central Bank supervisors to repay a 1.25 billion euro ($1.34 billion) 6.625% perpetual bond on June 3, the first chance it has to redeem it, the source said.

The bond reversed earlier losses to hit a session high after Reuters reported the request.

While UniCredit has signalled its intention to make use of an option to call the bond, it has until early May to make a final decision.

A supervisory source told Reuters that redeeming AT1 bonds is a good way to instil confidence in markets if banks have enough capital, which the source said is the case for UniCredit.

A spokesperson for UniCredit declined to comment. The European Central Bank declined to comment.

AT1 bonds are the riskiest type of debt banks can issue, ranking immediately after equity in the event of losses.

That hierarchy was overturned by Swiss regulators who wiped out $17 billion of Credit Suisse’s AT1 debt under its takeover by UBS.

The decision has disrupted the $275 billion AT1 bond market, which had already seen yields rise in the wake of recent U.S. banking failures.

Investors have priced in the risk banks will stop redeeming these perpetual bonds when they have an option to do so – which is standard market practice – given the cost of replacing them with new issues.

Yields have soared in particular on the bonds with a call date in the near future.

European rules require lenders to put in a request to supervisors to call an AT1 bond at least three months before the notice date.

If UniCredit’s bond is not repaid in June the coupon will reset at 638.7 basis points above the five-year mid-swap rate, meaning the rate would rise above 9%.

With 220 billion euros in liquid assets immediately available, well above its entire wholesale funding maturing within a year, UniCredit has flagged it might issue at most 1 billion euros in AT1 bonds in the course of 2023 depending on market conditions and balance sheet needs, a fixed income presentation showed.

The bank’s ‘CET1’ core capital ratio – a key measure of financial strength – was 16% at the end of 2022.

Even taking into account a large planned capital distribution through dividends and share buybacks, the CET1 ratio would stand at 14.9%, versus UniCredit’s own target of 12.5%-13% and a regulatory threshold of 9.2%.

AT1 bonds emerged in the wake of the global financial crisis as a way to build up bank capital and absorb losses. If a bank’s capital ratio falls below a certain level, the bonds convert into equity or are written down.

Bank shares and bonds fell sharply again on Friday on worries that regulators and central banks have yet to contain the sector’s worst shock since the 2008 crisis.

($1 = 0.9295 euros)

(Reporting by Valentina Za and Francesco CanepaEditing by Tommy Reggiori Wilkes, Elisa Martinuzzi, Louise Heavens, Kirsten Donovan)

---