Root Of The Fear: The $102 Billion of Bank Debt That’s Making Investors Nervous
Last year’s sure thing in credit markets is quickly becoming this year’s nightmare for bond investors.
The riskiest European bank debt generated returns of about 8 percent last year, according to Bank of America Merrill Lynch index data, beating every type of credit investment globally. In less than six weeks this year, those gains have been all but wiped out, even after interest payments.
Investors are increasingly concerned that weak earnings and a global market rout will make it harder for banks to pay the interest on at least some of these securities, or to buy them back as soon as investors had hoped. The bonds allow banks to skip interest payments without defaulting, and they turn into equity in times of stress. Deutsche Bank may struggle to pay the interest on these securities next year, a report from independent research firm CreditSights earlier on Monday said. The bank took the unusual step of saying that it has enough capacity to pay coupons for the next two years
The cost of protecting against defaults on safer U.S. and European financial debt known as senior unsecured notes has jumped to the highest level since 2013.
European banks are looking less solid since their last earnings reports. Deutsche Bank for example last month posted its first full-year loss since 2008, and its shares have plunged. Credit Suisse’s shares plunged to their lowest level since 1991 after the Swiss bank posted its biggest quarterly loss since the crisis.
Banks have issued about 91 billion euros ($102 billion) of the riskiest notes, called additional Tier 1 bonds,since April 2013. The problem is the securities are untested and if a troubled bank fails to redeem them at the first opportunity or halts coupon payments investors may jump ship, sparking a wider selloff in corporate credit markets, Merrill Lynch reported.
The cost of insuring Deutsche Bank AG’s bonds against default rose for an eighth day, even after the German lender said it had sufficient means to meet coupon payments on its riskiest debt this year and in 2017. Credit-default swaps tied to the bank’s junior and senior notes have both doubled in about three weeks.
COCO BONDS: How the Bank Debt That Everyone Is Talking About Works
What is a CoCo bond?
A contingent convertible capital instrument, or CoCo, is a type of bond designed by regulators after the financial crisis. The bonds allow banks to skip interest payments without defaulting, and they’re designed to convert to common equity or suffer a principal writedown if a bank runs into trouble. This provides a buffer in times of stress while inflicting losses on CoCo investors.
So how does it work?
CoCos typically allow a bank to stop interest payments when it runs into trouble, like when its capital ratios breach levels considered dangerous (that’s the “contingent” part). If the bank’s financial health deteriorates further, CoCos can force losses on bondholders. The bonds can lose their value entirely or change into common stock (that’s the “convertible” part).
How do banks determine whether they can pay?
This is where it gets really technical. To make optional payments such as dividends, bonuses and coupons on CoCos, banks must calculate their “available distributable items.” or ADIs. Deutsche Bank, which has to make the calculation based on its audited, unconsolidated accounts under German GAAP, has thinner coverage than other major banks, prompting the current volatility.
Why did regulators create CoCos?
During the financial crisis, taxpayers had to inject billions of dollars into failing banks, while investors in those lenders’ bonds were often fully repaid. Officials wanted to create ways to avoid this in the future.
What’s the issue now?
The market is only three years old and the securities are untested. Investors have threeconcernsgiven banks’ weak earnings and market volatility: that lenders will have to halt coupon payments, that they won’t buy back the securities as soon as hoped, and most of all that there will be a loss of principal.
What’s the fallout at Deutsche Bank?
The bank’s 1.75 billion euros ($1.98 billion) of CoCos fell to a record low of 70 cents on Tuesday versus 93 cents at the start of the year. Its senior bonds have fallen as low as 89 cents, while its shares have almost halved this year. Credit default swaps that pay out if Deutsche Bank defaults on its subordinate debts have more than doubled so far in 2016.
How about other CoCos? What’s going on with them?
Banks have issued about 91 billion euros of CoCos since April 2013. Investors piled into them last year, searching for yield, and were rewarded with returns of about 8 percent. Those gains have been all but wiped out in less than six weeks this year. Deutsche Bank isn’t alone; UniCredit SpA’s 1 billion euros of 6.75 percent bonds dropped to a record-low 72 cents after the Italian lender reported a decline in quarterly profit. Bonds issued by Barclays Plc, Lloyds Banking Group Plc and Royal Bank of Scotland Group Plc also fell.
Is there a broader risk?
The current volatility could damp investors’ appetite for CoCo bonds the next time lenders try to issue them, and a sell-off might bleed into the wider credit markets.
Spread More Than Doubles
The cost of protecting the company’s subordinated debt from default for five years using credit-default swaps has more than doubled since the end of 2015, rising to 438 basis points, a four-year high, from 187
CoCo Yields Soar
Bonds and stock of Germany’s largest bank have plunged this year, with the shares shedding 39 percent of their value and its contingent convertible bonds — known as CoCos, or additional Tier 1 securities — turning in a similar performance.
ITALY’S BAD LOANS: How Italy Seeks to Lure Buyers to Banks’ Bad Debt
After months of discussions, Italy and the European Commission reached an accord on a plan to ease the burden of bad loans on Italian lenders without breaching European rules. Concern over the swelling bad debt spurred a rout in banking stocks before the deal, and shares have since fallen further on doubts it will fix the problem. Here are some asked questions about Italy’s program. The answers are based on disclosures from the government, as well as conversations with analysts and investors.
How will the bad-loan program work?
Put simply, banks will be able to bundle their bad loans into securities for sale, while purchasing a state guarantee for the least-risky portions to make the debt more appealing to investors. The mechanics involve setting up a special purpose vehicle that will acquire the nonperforming loans, create the securities and sell them on to investors.
How have other countries done it?
Ireland and Spain both set up bad banks to clean up balance sheets of their failed and struggling banks. In both cases, transfers were mandatory and deep haircuts were applied. Ireland paid an average of 43 cents for each dollar of assets its bad bank took over.
Spain’s bad bank paid 47 cents. Both countries had to inject capital into banks which suffered major losses due to the transfers. Ireland ended up spending 64 billion euros for the rescues, forcing it to seek help from its European partners. Spain borrowed about 50 billion euros from the EU for its rescue. Both countries required or enticed private investors to be majority shareholders in the bad banks to keep the institutions’ borrowing out of their national debt totals.
The deep discounts on the loans during the transfer were required for the participation of outside investors. The Spanish bad bank has suffered almost 1 billion euros of losses in the last three years, despite the discounts, as prices dipped below the transfer rates. It has managed to sell only 14 percent of its portfolio so far. Its Irish counterpart has recorded over 1 billion euros of profit thanks to a recovering real-estate market and cheap funding costs. It has disposed of about 70 percent of its portfolio in four years.
Sources: Bloomberg, The Guardian, Google