Retail no answer for bank capital dearth

August 25, 2009

How does a bank raise capital when institutional investors are steering clear of hybrid debt? The dilemma may be particularly acute for Deutsche Bank, which is still in bad odour with some fund managers for not repaying some subordinated debt at the first opportunity this year as expected.

Deutsche has come up with an answer — bypass the institutional investors and flog some of your capital to the rich man in the street instead. The bank is marketing more than 300 million euros in fixed rate perpetual notes, yielding nearly 10 percent, primarily to retail investors.

If that yield sounds like a lot, it isn’t enough to tempt many asset managers who previously bought tier 1 debt securities. They are still nervous of the asset class because the European Commission is starting to demand banks spread the pain of bailouts with creditors by forcing them to defer coupons and not call debt.

Investors have also twigged that banks won’t always repay the bonds at the earliest opportunity just to please bondholders, as Deutsche illustrated this year. Some fund managers are now so sick of subordinated bank debt they want to have the bonds excluded from investment-grade bond indexes, as Reuters reported yesterday.

Retail investors may be less discerning. Perhaps they care less about the bank choosing to delay repayment and are less sensitive to the price volatility these instruments have displayed in recent months. The fear, however, is that they are simply being bamboozled by the yield, which may look juicy compared to paltry deposit rates but won’t mean much if the bank has to stop paying interest.

To be fair to Deutsche, it isn’t the first bank to issue retail tier 1 bonds so far this year and the rates are not scandalously low when compared to yields in the secondary market of about 9 percent or less.

It certainly won’t be the last bank to launch a retail offering. However, private investors alone will not solve the problem: 300 million euros is equivalent to less than 1 percent of Deutsche’s total Tier 1 capital.

The challenge for bank treasurers is to get the institutional market going again. It won’t be open for all. In the pre-crisis years, weaker banks had to pay only a percentage point more than their stronger peers. Now the tiering is far sharper, with stronger banks such as BNP yielding under or around nine percent, and weaker names north of 15 percent.

Banks will be prepared to pay up to raise new capital. Many banks need to repay government injections and unshackle themselves from the yoke of public sector scrutiny. A big coupon may be a small price to pay for freedom.

But investors must be wary of giving too much credit to high coupons. In the good years, hybrid capital paid them a small premium to senior bank debt. In the bad years they were left with heavy losses, and in the worst cases may lose all their principal.

This heads I win, tails you lose situation isn’t likely to come back anytime soon. Investors have learned the hard way that hybrid capital is different from senior debt. They will demand a greater share of banks’ revenues to compensate them and be less willing to fund weaker names. Overall, it means bank capital will be more expensive, and harder to come by.

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