The market for Tier 1 bonds looks to have re-opened with Deutsche Bank’s €1.25bn and SocGen’s €1bn deals announced last week.
That’s the first issue of ‘normal’ European Tier 1 bonds, also known as subordinated or hybrid debt, since BNP on Sept. 11 last year. The market for the stuff, which helps make up some of banks’ regulatory capital, was pretty much moribund after the financial crisis hit and various issuers declared non-calls and capital writedowns.
In fact, returns for the iBoxx Tier 1 index fell about 66 per cent between August 2008 and March 2009. They’ve since surged 150 per cent from their March low.
The sudden spate of new issues, however, makes for interesting timing.
For a start, you still have lingering questions over banks’ financial health. You also have a giant question mark over the bonds’ ratings given the European Commission’s new-found determinism to force bondholders to share some of the pain of state bailouts of banks — by, in some cases, forcing bailed-out financial institutions to defer coupon payments.
In addition, you still have the non-call issue on callable bonds, which is a type of debt that can be redeemed by the issuer prior to maturity — normally at a premium. Deutsche Bank managed to roil the bond market by not calling one of its Tier 2 bonds earlier this year, saying it was cheaper, at then-Euribor rates, to simply allow the debt to mature.
According to the analysts at Dresdner/Commerzbank, however, the no-call is, at this point, almost an implicit assumption in the market:
Overall, the investment-case for hybrid bonds these days is a lot clearer than it has been in the past: high coupon, but also with the risk of non-payment in the case of negative results. In this, the ‘New’ Tier 1 resembles more the classical German Genusschein — participation capital with high, but profit dependant coupons. Also, it should be clear that call options will be exercised only on economic grounds.
Analytically the situation has become a lot more challenging, as proper valuation now requires stochastic calculus to evaluate the non-payment option and the call option. Bloomberg’s YASN function goes a long way to providing a comprehensive evaluation tool. But in the face of this analytical challenge, and the many unknowns involved, the market appears to have taken a very pragmatic approach and prices most existing Tier 1 issues as truly perpetual. The key number therefore is simple yield, i.e. coupon divided by the price of the bond. Using this metric, it becomes clear that there are four distinct groups of bonds out there right now (see also Chart 2 below)
- The Ugly — running yields above 15% indicate a strong non-payment risk. Currently some issues from British and Irish banks with state help approach this threshold.
- The Bad — running yields between 10% and 15%. Mostly banks where governments have taken a major capital stake.
- The Good — 8% to 9% appears to be the norm for those banks that only participated in guarantee programmes and have no significant state participation. The vast majority of bank Tier 1 issues fall into this category.
- The Unaffected — Less than 8% running yield can be found for non-banks as well as some issues by the banks that have come through the crisis largely unscathed — BNP, HSBC and BBVA.
What seems to be developing then is a rapid division between the heroes and non-heroes of the hybrid world — that is, those banks who were bailed out by their respective governments, and therefore have a high probability of coupon deferral risk, and those that managed to survive mostly without state aid.Combined with the no-call issue, and you may have some interesting bond market developments, according to Dresdner/Commerzbank:
Currently, we see ourselves drawn to the ‘no-call’ camp. Increasing loan provisions, and the fate of many — albeit smaller — US Banks being shut down by the FDIC clearly underline the existing risks for banks. Calling cheap Tier 1 bonds in this environment is a low-likelihood option. This is likely to change by 2011, and at the latest in 2013, when some of the 8%+ bonds issued since 2008 have their first call dates. Some bonds will eventually be called, and appreciation potential depending on market conditions remains significant. The re-opening of the market also increases the chance that trends in primary markets will influence price action for secondary issues. The running yield should thus generally be the lower boundary for expected returns — as long as coupons get paid. This is of course far from certain, and as the vast majority of outstanding hybrid bonds are non-cumulative, scenarios where recently issued bonds do not pay coupons for most of their lives but are eventually called are possible — as well as scenarios where investors end up with worthless irredeemable zero-coupon bonds.
Related links:
Hybrid security (or not) – FT Alphaville
Deutsche bonds with the retail investor – FT Alphaville
Who’s callable in 2009? – FT Alphaville