“It’s the epi­cen­ter of growth con­cerns glob­ally. And it doesn’t look pretty”

An odd kind of bank bond called a CoCo starts to look shaky It’s an in­stru­ment “of reg­u­la­tors, by reg­u­la­tors, and for reg­u­la­tors”

Bloomberg Businessweek (Asia) - - CONTENTS - −Tom Beardsworth and Cordell Ed­dings

Shares in Deutsche Bank tum­bled on Feb. 9 to their low­est point since 1992. The big­gest thing driv­ing in­vestors’ pes­simism: a re­port from in­de­pen­dent re­search firm Cred­itSights that said the Frank­furt-based bank might strug­gle to make its pay­ments next year on con­tin­gent con­vert­ible bonds, also known as Co­Cos. Deutsche Bank took the un­usual step of say­ing that it can make pay­ments on the bonds for the next two years, and its shares ral­lied 4.6 per­cent on Feb. 10 on re­ports it might buy back some debt.

The shake-up put a spot­light on Co­Cos, which are no or­di­nary bonds. Un­til re­cently, the in­stru­ments mainly is­sued by Euro­pean banks were the best bet on the global credit mar­kets, gen­er­at­ing re­turns of 8 per­cent in 2015, ac­cord­ing to Bank of Amer­ica Mer­rill Lynch in­dex data. Their yields av­er­age a fat 7 per­cent when short­term rates in Europe are neg­a­tive. But that’s a re­ward for risk: The bonds al­low banks to skip in­ter­est pay­ments with­out de­fault­ing or even con­vert the bonds into equity in times of fi­nan­cial stress—bad news for in­vestors who had planned to col­lect their in­ter­est and prin­ci­pal.

Now bond mar­kets are pay­ing at­ten­tion to the down­side. In less than six weeks this year, CoCo prices have dropped far enough to wipe out the 2015 gains. Euro­pean banks are look­ing much less solid since their pre­vi­ous earn­ings re­ports. Deutsche Bank last month posted its first ful­lyear loss since 2008. Credit Suisse Group— which hasn’t been the fo­cus of the same debt wor­ries—in Fe­bru­ary re­ported its big­gest quar­terly loss since the fi­nan­cial cri­sis. In­vest­ment bank­ing rev­enue in Europe is shrink­ing, even as tum­bling oil prices, China’s slow­down, and a global mar­ket rout are mak­ing the banks’ loans and in­vest­ments look riskier.

“The wor­ries about th­ese bonds rep­re­sent real fears that the Euro­pean bank­ing sys­tem may be weaker and more vul­ner­a­ble to slow­ing growth than a lot of peo­ple orig­i­nally thought,” says Gary Her­bert, a fund man­ager at Brandy­wine Global In­vest­ment Man­age­ment. “It’s the epi­cen­ter of growth con­cerns glob­ally. And it doesn’t look pretty.”

As risky as CoCo bonds are for their in­vestors, they were de­signed to make the banks safer—or at least less likely to need a govern­ment bailout. Be­cause the banks aren’t ob­li­gated to make pay­ments in a time of cri­sis, sell­ing Co­Cos lets them raise money with­out in­creas­ing their ul­ti­mate risk of in­sol­vency, at least the way reg­u­la­tors look at it. As a re­sult, many Co­Cos have helped banks meet new, higher cap­i­tal re­quire­ments.

Crit­ics of the bonds say they are too com­plex and banks are too opaque. “Ba­si­cally you have the up­side of fixed in­come and the down­side of equity,” says Gil­das Surry, a port­fo­lio man­ager at Ax­iom Al­ter­na­tive In­vest­ments. He calls the bonds “in­stru­ments of reg­u­la­tors, by reg­u­la­tors, and for reg­u­la­tors.”

In­vestors aren’t con­cerned only about missed in­ter­est pay­ments. The bonds can typ­i­cally be bought back by the bank af­ter five years, but this isn’t re­quired. Ris­ing bor­row­ing costs may make banks less likely to re­deem, forc­ing in­vestors to hold the bonds longer than they might have ex­pected.

Banks have is­sued about €91 bil­lion ($103 bil­lion) of Co­Cos that reg­u­la­tors count as top-tier cap­i­tal. They are rel­a­tively un­tested, and if a trou­bled bank fails to re­deem them or halts pay­ments, in­vestors may jump ship quickly, po­ten­tially spark­ing a wider sell­off in cor­po­rate credit mar­kets.

For now, money mar­kets show lit­tle sign of sys­temic debt con­cerns. One key in­di­ca­tor of fear is the two-year euro in­ter­est rate swap spread—the dif­fer­ence be­tween what banks and gov­ern­ments must pay to bor­row. The gap was 0.35 of a per­cent­age point on Feb. 8, less than the five-year av­er­age of 0.49 of a point. The spread hit 1.26 points dur­ing the fi­nan­cial cri­sis.

That’s not re­as­sur­ing CoCo in­vestors. “In a nor­mal mar­ket, this would be a great time to buy, but ev­ery­one is afraid to step in,” says Tom Voorhees, a bond trader at Brean Cap­i­tal. “Ev­ery­one is look­ing for the door at the same time.”

The bot­tom line CoCo bonds are meant to be safe for the bank that is­sues them but risky for in­vestors who buy them. The risk is now clear.

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