When European regulators created a new type of bank debt, the idea was to transfer risk from taxpayers to investors. Now bondholders are learning what that really means.
Yield-starved investors bought $102 billion of the contingent convertible bonds, securities created to help troubled banks hang onto cash in times of stress by skipping coupon payments without defaulting and converting the debt to equity or writing it down. Even though neither of those has yet happened, investors are already feeling the pain, as yields on Deutsche Bank AG’s 4.6 billion euros ($5.2 billion) of CoCos have soared and its shares have plummeted.
“CoCos are a perfect pro-cyclical storm — you can sell billions of them when investors are yield-chasing and thus careless of risk,” said Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics. “In a yield-chasing stampede like that of the last few years compounded by ultra-low rates for other bank funding sources, banking-system risk is dramatically heightened.”
The yield on Deutsche Bank’s 6 percent CoCos in euros rose to more than 13 percent from 7.5 percent at the start of the year. The bank’s shares are down 40 percent in the same period.
The securities, designed to absorb losses and protect European taxpayers from funding bailouts, are facing their first test as weak bank earnings and a global market rout raise concerns about banks’ stability and growth. Deutsche Bank last month posted its first full-year loss since 2008, and its shares have plunged. Credit Suisse Group AG’s shares slid to their lowest level since 1991 after the Swissbank posted its biggest quarterly loss since the financial crisis.
Deutsche Bank Co-Chief Executive Officer John Cryan was forced to reassure investors and staff that the bank is “rock solid” after the shares erased almost 2 billion euros of the company’s market value on Monday.
Prices of CoCos, also known as additional Tier 1, or AT1, instruments, have over-reacted because some investors failed to understand what they were buying, said Francois Lavier, who oversees investments of $3.4 billion in bank debt at Lazard Freres Gestion in Paris.
“There are discrepancies in the market, not because of fear that Deutsche Bank or whoever will go down, but because some of the bonds are in stable hands and others aren’t,” Lavier said. “In a market where there isn’t any liquidity and isn’t working well, these are the results.”
AT1 CoCos work in two ways, both designed to recapitalize a distressed bank while keeping it as a going concern.
When capital ratios fall below an agreed level, typically either 7 percent or 5.125 percent, they convert to equity or are written down. The risk that investors are focusing on now is that borrowers can skip a coupon payment without defaulting. And interest on AT1 bonds is “non-cumulative” — which means that a missed interest payment is gone forever.
The lowest-priced CoCo bonds are now pricing in an average of three years of skipped coupons, according to analysts at JPMorgan Chase & Co. in London.
“The market is forecasting that banks will have credit losses greater than their reserves, and large enough to hit capital buffers,” said Mark Holman, chief executive officer of TwentyFour Asset Management in London. “You’d need an awful lot of bad news to justify prices being where they are now.”
Regulators created the bonds in 2013 to meet new risk criteria set out by the Basel Committee on Banking Supervision. The first AT1 bonds were tough to sell because they were unfamiliar and risky, according to Peter Tchir, a strategist at Brean Capital in New York.
Then, as the market developed and grew, “reservations were left behind — what was once a complex security requiring great selling effort had developed into something that could price as a ‘drive-by,’” Tchir said in a note.
Now, for some investors, CoCos are suddenly too risky to hold, and they are dumping them at whatever price they can get.
Lavier points to the contrast in the performance of Intesa Sanpaolo SpA’s 8.375 percent hybrid note sold in September 2009, before the birth of the CoCo market, and the CoCo bond it issued in January, both of which are Tier 1 instruments that would be impaired in a crisis. The first has fallen about 6 cents on the euro to 108.4, while the second, the CoCo, issued at par on Jan. 12, fell as much as 15 cents and was at 85 cents today.
“These are small flows in a very illiquid market that’s driven only by sentiment,” said Lavier. “These two are the same risk. So forget fundamentals, this is a crazy market.”