Fears for bank rally overdone
Three months is a long time in the markets, and particularly for banks. Alongside the rally in bank shares, investors have also bid up bank bonds, especially so-called tier 1 bonds which rank just above the equity in the list of creditors.
In some cases, the prices these bonds have tripled and, overall, yields to perpetuity have halved across the sector, according to Morgan Stanley.
This rally has now overshot and the risks are on the downside. Despite being labelled debt, tier 1 is pretty much like equity: issuers can stop paying coupons, the coupons do not always accumulate if missed and the issuer can choose not to “call” (redeem) them at the call date.
So the additional protection they offer over bank equity is not great. This is why prices crashed last autumn along with those of bank equity.
Over the past couple of months, confidence has returned as governments across Europe have recapitalised their banks, removing the risk of a systemic failure.
The ensuing confidence has enticed private banking clients — who are missing the income traditionally provided by dividends and bank interest — into this market.
Moreover, banks have themselves been buying back their own debt, trying to lock in the “profit” that many have booked on the write-down in the value of their debt.
Institutional investors have committed much of their substantial cash holdings to this market too. These factors have driven up prices.
However, the juicy yield that has enticed recent buyers may simply disappear: issuers could simply pass the coupon.
This is what has happened with Bradford & Bingley, a failed British bank whose loan book is being run down by the British government. Last week’s announcement failed to damage other bonds, suggesting that investors see B&B as a special case.
This assumption may prove too optimistic. Most banks are short of cash and will be tempted not to pay their tier 1 coupons if they do not have to.
This is especially true of state-owned banks, like RBS and Lloyds, and Ireland’s AIB and Bank of Ireland that are not paying dividends.
Their state paymasters may consider “optional” coupons to be a poor use of precious capital.
Moreover, the European Commission may stop them from doing so. It has already prevented Commerzbank from paying out on hybrid bonds.
The Commission is currently examining the British and Irish state guarantees and may conclude that insolvent banks should not be making discretionary payments to bond-holders who, after all, are typically institutional investors who should understand the risks inherent in such instruments.
The biggest risk — that investors will be wiped out by nationalisation — has not gone away, even if it has subsided.
If banks do need any more government bail-outs, the terms are likely to be harsher than in the past. Even in the absence of full-on nationalisation, governments may choose to impose a debt-for-equity swap on bondholders.
After all, everyone else — depositors, shareholders, taxpayers — have borne some pain. Why should bondholders be any different?