Investors retreat from risky European bank bonds

Higher-risk European bank debt tumbled in price on Monday, as investors scrambled to offload bonds that are first to be hit if financial institutions run into serious trouble.

The value of additional tier 1 (AT1) bonds issued by major banks declined dramatically almost across the board, on a day when the Euro Stoxx bank equity benchmark had another tough day, down more than 11 per cent. One of the sharpest fallers was Deutsche Bank, whose $1.25bn AT1 bond dropped more than 10 cents to 61 cents on the dollar. It had been sold to investors at face value a little over a month ago.

“People have blindly, indiscriminately piled into [AT1s] and they are getting massacred out there,” said a senior European investment banker.

AT1 bonds were introduced by regulators after the financial crisis to shore up banks’ balance sheets. The equity-like instruments have high coupons and perpetual maturities, meaning that banks do not need to repay the principal. But crucially, the bonds can also be written off if the lender trips certain thresholds of viability. As a result they are often known as “contingent convertibles”, or cocos.

While cocos were one of the best returning fixed-income assets last year — with ICE Bank of America’s index posting total returns of almost 18 per cent — investors are now sitting on big losses in 2020. Pimco’s $8bn capital securities fund, which had cocos as its top five holdings at the end of 2019, was down nearly 13 per cent for the year through to Monday.

One hedge fund manager said that while many AT1 bond prices had reached attractive levels, he was still waiting on the sidelines as he believed they would move even lower. He said this could happen if some of the big funds that offer their investors the ability to withdraw their money on a daily basis have to sell large volumes of cocos later this week. 

“The drawdown for some of those funds will be brutal,” he said. “After today’s performance, you’ll see some of the dedicated coco funds down 12 to 15 per cent. Then the outflows could really start.” 

Deutsche Bank last week became the first major European lender to announce this month that it is not “calling” an AT1 bond, opting not to exercise an early repayment option on $1.25bn of capital it raised in 2014. Investors have in the past been wrongfooted by such decisions. Bonds from Santander were badly knocked last year after the Spanish lender surprised the market by not repaying a coco bond early. 

In contrast, Dutch lender ING announced it would repay one of its AT1 bonds on Sunday, which investors said was a way to signal to the market the strength of its balance sheet.

“I think that the strong banks that are able to do it, will do it,” said Jérôme Legras, head of research at Axiom Alternative Investments. “They will be keen to show that they are indeed strong.”

Investors also rushed to buy a widely traded basket of credit-default swaps that can be used to shield them from losses on bank bonds that rank behind “senior” debt. The cost of buying Markit’s Europe subordinated financials index spiked above 300 basis points on Monday, having traded at less than 100bp a month ago. 

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