Markets are still coming to terms with Deutsche Bank’s decision not to call its LT2 bond yesterday. It was a big deal — it’s never happened with these kinds of Lower Tier 2 bonds before.
The market had (reasonably) been expecting DB to call the notes in, at par, on Jan. 16. The bond issue was a 10-year deal, with a call date after 5 years (this January). A callable bond, as a reminder, is a debt that can be redeemed by the issuer prior to maturity — normally at a premium. The capital raised goes towards banks’ Tier 2 capital. That’s obviously different to Tier 1, the important stuff that regulators look at, but it could nevertheless affect it.
Dresdner’s Nigel Myer and Folkert Jan Van Der Veer comment:
While we have long wondered about the real value of LT2 from a capital perspective because it doesn’t absorb losses on an ongoing basis and hence provides no meaningful protection other than in default, we have always seen call options as effectively mandatory.
The ‘mandatory’ nature arises (or perhaps used to arise) due to the peculiar nature of the arbitrages that come together to form banks’ regulatory capital instruments. The need to meet regulatory requirements, capital efficiency, tax rules and investor desires has led to call options frequently being embedded in bonds. Cost effectiveness was achieved through the inclusion of the call and step and the unwritten obligation to call. So, in essence the borrower ceded the right to exercise the option in return for the investor pricing the bond to the call date.
That was the deal. And now it’s broken and investors are angry. Very angry. Bond Vigilantes put it rather mildly yesterday:
So LT2 bonds are lower this morning, but a bigger hit is likely in the even more subordinated Tier 1 (T1) market. If banks now feel no moral pressure to call the more senior Lt2 bonds, they will certainly have no compunction about letting T1 bonds extend maturity – to perpetuity if necessary. And coupled with the fact that many T1 bonds will not be able to pay coupons if the bank isn’t paying an equity dividend, many investors are going to be left holding zero coupon perpetual bonds. Bond Maths 101 – the zero coupon perpetual bond is the very worst kind of bond you can own. T1 bonds are 10-12 points lower this morning.
Dresdner goes even further:
Narrow financial logic has never before prevailed in regulatory capital. Deutsche’s decision not to call an LT2 bond is a step change and represents the storming of one of the last bastions of presumed behaviour in the credit markets. Investors understand the rationale. They don’t like it. What they do about it is much more important than the near term transfer of value from bondholders to issuer.
But they also explain the impact on the DB itself (emphasis our own):
If the call-and-step structure is no longer credible because Deutsche has set a new trend, then issuers will have to pay more for their LT2 than before. To be sure, at current spreads in current markets, that is difficult to quantify, but in normal times it can be a big issue.
It is also likely, we think, in this situation, that the structure of Tier 1 will have to be rethought or repriced: as perpetuals they depend on an implicit maturity date to reach a broad investor base. On top of this, some investors have suggested they will shun all Deutsche paper, senior and subordinated, short and long term, as a mark of annoyance. That could have far reaching implications if sufficient investors joined a strike.
That’s why we think talk of a DB accounting conspiracy theory is perplexing — though not implausible. Particularly this one, from a trader, which is zipping around the City this morning:
Deutsche Bank has been one of the more aggressive European banks when it comes to using all the accounting tools available to dress the balance sheet including using fair value accounting for their liabilities. As we all know this means that the wider their funding spread goes the more money they make on their outstanding borrowings.
My guess is that under conservative accounting rules DB is required to value the callable liabilities to the call date when taking gains under fair value accounting. However by not calling this deal they can now value it to maturity resulting in an immediate gain of around EUR 100mio (10% in price). Even more importantly they can apply the same principle across all their callable capital instruments giving a huge potential one-off gain. Of course this gain will amortise to maturity but it does give DB a place to hide some more writedowns for a while.
That seems doable to us. However, the price for doing so — the potential destruction of an important source of Tier 2 (and possibly and certainly more importantly, Tier 1 capital), for the sake of hiding writedowns, seems extreme. But then again these are extreme times.
Bond Vigilantes, it should be noted, is already suggesting that investors start assessing LT2 bonds on a yield to maturity basis rather than a yield to call basis.
As they put it:
… in other words the spreads being offered on bank bonds were unrealistically high if quoted to those shorter call dates.
Banks could presumably be doing the same.
Related links:
Deutsche Bank didn’t call one of their bonds this morning – Bond Vigilantes
Deutsche rattles the bond market - FT Alphaville