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The Euro-Zone: The Cyprus syndrome

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Helen Fowler finds the risk-reward balance across European bank debt changing rapidly following recent resolutions

The Cypriot banking crisis has served as a watershed for banks around the world. Even uninsured deposits do not necessarily enjoy the immunity that many imagined they did. It is therefore no surprise that the assumption that senior debt enjoys any real advantages over junior paper when it comes to government intervention is evaporating.

The bail-out part of the €10bn Cypriot rescue deal involved the so-called ‘Troika’ providing refinancing assistance to the sovereign, to avoid banks having to write down the value of their bond investments. The ‘bail-in’ side forced the Bank of Cyprus, the island’s largest lender, to draw upon the capital provided by its shareholders, bondholders and even depositors. The restructuring involved a conversion of at least 37.5% of uninsured deposits over €100,000 into equity as a condition.  

“Up until now, politicians have been too nervous to implement a bail-in,” says Tamara Burnell, head of financials and sovereign credit analysis at M&G Investments. “In Cyprus, there was no option. It’s the closest thing to a bail-in we’ve seen. The press has talked about money launderers in Cyprus, but not about what happens to inter-bank deposits by institutions, derivative counterparties and various wholesale creditors. It still isn’t fully clear what their recoveries will be or which ones will be protected.”

Investors are coming to terms with the fact that future bank bail-ins will probably extend as far as holders of senior unsecured debt, which used to rank pari passu with depositors.

“Cyprus was a game-changer, a watershed,” says Garrett Walsh, head of credit research Europe at Pioneer Investments. “I’m not sure the market has fully appreciated the risks associated with the write-down of senior debt at Laiki. Prior to Cyprus, senior unsecured pretty much benefitted from an implicit guarantee from the ECB.”

The authorities imposed losses on senior unsecured debt at Laiki Bank as well as Bank of Cyprus, and from January 2015, the EU Resolution Regime Directive will formally permit senior debt to be bailed in and market practitioners feel that it is likely to clarify its subordination to deposits, short-term inter-bank claims and CCP-cleared derivative positions.

“People realised from Cyprus that senior bondholders and other creditors, including depositors, would be treated as fairly junior and that the label ‘senior’ didn’t mean much in practice,” says Burnell.

“It looks almost certain that depositors will be given preference to senior,” says Walsh.
“There is an increased risk for senior bondholders, with potential bail-ins for the next year and a half,” says Caspar van Grafhorst, senior investment manager at ING Investment Management, which remains underweight senior unsecured bank capital. “From 2015, we expect it will be possible to bail-in senior debt under the European resolution and we don’t think the potential 2015 bail-in of senior is priced in yet.”

There is a continued shift in investor preference towards covered bonds, which effectively rank above senior unsecured debt in the capital structure because of their claim on a specified collateral pool. The new Resolution Regime proposal only allows regulators to remove excess over-collateralisation from covered bonds to shore up a balance sheet. In the years following the financial crisis, there has been a surge in issuance of covered bonds, to replace increasingly expensive unsecured funding – although only €29bn worth was issued in Q1 2013 as banks continued to enjoy access to ECB funding.

To compensate for its underweight in senior bonds, ING Investment Management is investing in covered bonds as an off-benchmark bet, and Pioneer Investments also sees covered bonds as attractive following events in Cyprus.

However, at the same time there is continued appetite for debt higher up the list of securities that shoulder losses when a bank fails. “Where we like an investment case, we would really rather own its subordinated debt and move down the capital structure to get extra yield,” says Walsh. “On a risk-adjusted basis, you are getting well paid to buy tiers one and two, but you do need to be selective.”

ING confirms that is also slightly overweight tier-2 bonds.

Even further down the capital structure, on a selective basis, the hybrid contingent capital notes (cocos) issued as loss-absorbing capital are proving popular.

“It all depends on the bank and issue,” says ING’s Van Grafhorst.
Walsh notes that the structures differ substantially. “We are not particularly keen on recent structures from Barclays and KBC, where you get written off before equity investors,” he says. “We prefer cocos with lower trigger levels and instruments which offer a degree of protection.”

Instead, Pioneer has invested in the recent €1.25bn, 10-year fixed rate senior contingent note from Rabobank, for example, which came to market at a premium to Rabobank subordinated paper and a discount to where the bank would have been able to complete a hybrid tier-1 offering. It also invested in BBVA’s additional tier-1 capital issued in early May, one of the first to comply with the Capital Requirements Directive (CRD IV). Investors piled into the new deal, which attracted $9.25bn (€7.13bn) for a bond sized at $1.5bn. The bond converts into equity if BBVA’s core equity tier-1 ratio falls below 7%, (it currently stands at 11.2%).

Clearly, when buying a coco, a lot of the consideration centres on the likelihood of the issuer triggering its tier-1 threshold.

“The likelihood at this time of a leading bank breaching its tier-1 capital is small, but at some point the cycle will turn – banks will underwrite bad loans, or risk-weighted assets will be calibrated more conservatively,” says Phillip Jacoby, CIO at Spectrum Asset Management, a credit investment firm that specialises in the sub-ordinated bonds of high-quality issuers.

The individual circumstances of each bank are becoming more pertinent in the current climate. “The work of banking analysts is becoming more and more important following what happened at SNS Reaal,” says van Grafhorst of ING Investment Management, referring to the Dutch entity nationalised in February 2013. “We are looking at banks on a case-by-case basis.”

In the US, the hierarchy of claims in insolvency has already been clear for some time, with insured and uninsured deposits ranking ahead of unsecured debt. As a result, there has been minimal disturbance to US capital markets following Cyprus and a flurry of bank bonds has been issued as lenders take advantage of a recent decline in benchmark borrowing costs and demand for high-grade securities. Wells Fargo, Hartford Financial Services, First Republic Bank and JPMorgan Chase were among the financial institutions to raise funds in April.

In Europe, where the resolution regime is in flux and where banks have made much slower and more tangled progress towards de-leveraging, investing in bank debt has become a much more complex – but potentially more rewarding – prospect.

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