Thursday, December 18, 2008

Deutsche Bank refuses to redeem bond issue

From the FT's Lex:

To assume makes an ass out of you and me, runs the old adage. Investors were reminded of this after Deutsche Bank on Wednesday broke with convention, becoming the first big bank not to exercise a call option on its subordinated notes. This debt, popular among European banks, counts as lower tier two capital and is typically structured as a 10-year issue which can be called, or redeemed, after five years. There is no obligation. But such debt has previously been bought and sold on the basis that banks would exercise their right without fail.

This was not an unreasonable bet in the past. A rise in the coupon after five years, plus the amortisation of the notes’ contribution to regulatory capital, incentivises banks to call their bonds. In current markets, however, Deutsche quite reasonably would prefer to pay the still-attractive stepped-up rate of interest rather than face a costly refinancing – saving perhaps €150m. Shareholders should applaud this economic logic.

Debt investors, though, expecting to receive face value in January, are squealing. Deutsche may now call the debt quarterly, making valuation tricky. More broadly, similar securities – of which about €11bn were due to be called between this month and July – on Wednesday fell in value on worries that other banks would follow Deutsche’s lead. This type of debt has already faded in importance for banks, given an increased focus on tier one from regulators. But a further concern is that callable tier one instruments may be next, which could see investors potentially stuck holding perpetual, non-cumulative notes ad infinitum.

Banks’ reputational risk, after all, is not what it once was, while capital preservation is top priority for regulators. Investors, perhaps, should have realised that the regulatory classification of these instruments, similar to equity, suggested that the option not to call was a real one. Upended assumptions mean a subordinated debt shake-up next year.

Here's the full story from the FT:

Deutsche Bank jolted bond and equity investors on Wednesday when it became the first big bank to say it would not repay €1bn ($1.4bn) of a particular kind of bond as expected in January.

The move raised fears about Deutsche’s capital strength and signalled a much higher likelihood that other banks would follow the example in not repaying so-called hybrid-capital bonds.

This could, in turn, erode the market for hybrid capital deals, which are supposed to occupy a kind of grey area between debt and equity. These instruments have been hugely important in squeezing extra funding into bank balance sheets – and in propping them up since the financial crisis exploded.

The bonds are typically repaid at the first opportunity after an initial period when redemptions are not allowed. If an issuer does not redeem then, they must pay a higher penalty coupon rate.

Deutsche Bank decided it was more cost-effective to pay this penalty rate rather than replace the funding in current difficult market conditions, which have made finance more expensive.

More than $800bn such bonds have been issued globally this decade, according to Dealogic, hitting a peak of $175bn in 2007. Most of the issuance has come from banks. Their importance in supporting bank balance sheets during the crisis is shown in the $137bn of deals in the past year.

When banks decide not to redeem the bonds at the earliest opportunity, the market value of the instruments falls, hurting investors. Analysts and bankers said such a scenario could see investors turn away from buying these deals in the future – further narrowing banks’ ability to raise new money.

“Deutsche Bank is running the risk that this may be seen as more symptomatic of capital and funding pressures which the institution may be facing,” said Roberto Henriques, credit analyst at JPMorgan.

The €1bn bond, which is part of Deutsche’s Tier 2 capital, an important but not core element of its balance sheet, has its first call date in mid-January.

The bank’s shares were on Wednesday down 7 per cent to €26.04, while the bonds in question dropped by up to 10 per cent to be worth less than 90 per cent of their original value, according to traders.

More than €33bn worth of these deals are due to be called next year by a string of banks, but that now looks less likely.

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