The Dawn Of New Bond Concern
Over the ensuing months the canary that was Bear Stearns fell from its perch as its hedge funds failed and the bank came under increasing financial pressure, before being sold to JP Morgan at a fire sale price.
Thankfully for the bondholders the new owner took on the debt obligations of the failed bank, a pattern that repeated through the crisis with bondholders being largely spared any loss burden as losses mounted and multi-billion dollar bailouts propped up the financial system.
Ten years on and there is a newer class of debt in the bank capital structure known as ‘contingent capital’ bonds, or ‘CoCos’, which were designed to add an additional loss absorbing layer to an issuer’s tier one equity.
They are also known as alternative tier one bonds or ‘AT1s’.
Usually they will have a pre-determined common equity tier one (CET1) ratio trigger level at which the bonds will convert into equity or be written down.
To compensate the investor for this additional risk the bonds typically pay a high coupon and in this low yield world demand and issuance has been robust with nearly $200bn additional capital raised through these bonds.
This month we witnessed the first conversion of one of these bonds when Banco Popular, a Spanish lender, was on June 7th sold for the token price of 1 Euro to Santander.
'Coco' pops - be warned!
This followed liquidity concerns that led Europe’s Single Resolution Board to conclude that the bank had reached the ‘point of non-viability’, and overnight the equity and junior debt was essentially wiped out.
Investors in the AT1s might feel aggrieved as the bonds had trigger levels of around 7% and 5% whilst recently CET levels were still reported to be double digits. However, this speaks to an important point that it is the local regulator which determines viability, not the bank itself, and the axe will likely fall well before prospectus tier one trigger levels are reached.
The fallout from the event was limited however, and the sector as a whole has held up well, far better than early 2016 when concerns over Deutsche Bank led the whole sector sharply lower before later recovering those losses.
This swift regulatory led action has shone the spotlight once again on European banks’ huge exposure to non-performing loans (NPLs) which weigh heavily on their operations and capital ratios. The shares and subordinated debt of Liberbank, a smaller Spanish lender with significant NPL exposure, came under pressure following the sale and the Spanish regulator has since banned short selling of its shares.
The fattest canary though undoubtedly chirps an Italian tune with NPLs in that country estimated to be in excess of 250bn Euros, with several Italian banks now finding themselves the unwanted centre of attention.
Although fallout from the Banco Popular sale has to date been limited we are cognisant that now the regulator’s weapon has been fired to seemingly good effect, they will be closely watching developments elsewhere.
At Momentum we recognise the stark asymmetry embedded in these bonds and for that reason we only have minimal exposure to the sector through a specialist active bond manager.
It is not an asset class where you want a passive, index like exposure, as credit selection really is crucial in this still young and largely untested market.
In these more specialised asset classes we prefer to use smaller, more dynamic managers, who are not forced to own sectors or issues because of their size. Indeed, the largest holder of the now worthless Banco Popular AT1 bonds was one of the best known managers on the street. Not so popular now.