As EU legislators subordinate the asset class in bank-resolution plans, the jury is sharply divided whether bail-in risk is – and should be – priced in the bank-funding market and the extent to which policymakers will make good on their threat to re-privatize bank liabilities.
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| Jeroen Dijsselbloem, Eurogroup president, who cited the Cyprus 'template' |
Underscoring the regulatory momentum, last week the European Parliament’s Economic and Monetary Affairs Committee voted to place senior unsecured bondholders below even uninsured depositors in the pecking order during a bank-rescue, removing the once-cherished taboo of imposing losses on bondholders.
Policymakers are also pushing to make bank-resolution plans formally operational from 2016, rather than the original 2018-2019 start-date.
However, these draft bail-in plans need to be rubber-stamped by member states by the end of this summer, raising the spectre of delays and revisions, though no member state disputes legally entrenching the structural subordination of bondholders, in favour of depositors, through harmonized contract.
Nevertheless, there has been little movement in credit default spreads and cash bonds in the senior high-rated bank debt market in core Europe, in part, suggesting investors have largely shrugged off the impact of the Cyprus crisis and legislative efforts to expose bank debt to a bail-in to minimize the need for taxpayer-funded bailouts.
What’s more, positive technicals – principally a lack of supply and excess liquidity – have served to cap new issue premia in the primary high-grade FIG bond market.
CreditSights sums up the bullish allocation pitch based on fundamentals, citing the de-risking of bank balance sheets and greater regulatory vigilance: “The last six months have demonstrated that fixed-income investors have a higher degree of interest rate sensitivity but they remain comfortable with credit risk.”
Jury divided
At a recent AFME meeting in London, the mood was distinctly sour as investors grappled with the systemic changes to the asset class, though the Cyprus bailout was seen as a confirmation of a long-standing policymaking bid to force bank investors to shoulder the burden for bailouts.
Fiona Macnab, executive director in global fixed income at Goldman Sachs Asset Management, reckons 2013 is the year that the anomaly – bondholders have largely been insulated from haircuts to date, outside of liquidation – is corrected.
“Cyprus was not a surprise,” she said. “After the crisis, subordinated coupons were paid on bank debt even though the issuers had the option not to – that was not how [the resolution] is supposed to work.”
The jury was out on whether yields on senior unsecured debt should reflect a premium for the risk of regulatory restructuring outside insolvency as well as default risk.
Citing Fitch data that highlight that the five-year global cumulative failure rate – ie banks that have defaulted or would have defaulted had they not been rescued – is 7.1%, Macnab said the prospect of diminished state support means bank-default risk would now have to be priced in as the failure rate and default risk converges. (State support, therefore, reduces bank default risk by a factor of eight over a five-year period, using this Fitch data.)
“Banks fail very regularly,” she said. “According to Fitch, there is a 7% failure rate in bad times and 4% in good times. So we do have a history of bank failure. Resolution should not be dirty word. The sovereign has typically backed up banks so default has, historically speaking, been less than 1%. We are now moving from 1% to a world of 7% or 4%.”
This view was sharply disputed by Roger Doig, credit analyst at Schroders, at the same meeting. “As a senior investor you are not taking on credit risk – you are providing duration and funding.
“There is no idea that you are being really rewarded for taking credit risk. And there should be no prospect that losses should be imposed on creditors. It is clearly different for those that have invested in subordinated instruments.”
While most fixed-income senior investors are bearish about the prospect of government support, but take comfort from the increased layers of protection in the form of loss-absorbing capital, subordinated debt and then equity, Doig struck a contrarian tone: “There are banks out there that are de facto too-big-to-fail,” restating the argument that, in the main, investing in senior investment-grade bank debt is a duration, rather than credit, play.
He added: “By and large, there is very little credit risk at the senior level in European banks any more.”
The market disagrees. A Fitch November 2012 report suggests more than a third of western European bank ratings received “uplift often of multiple notches due to sovereign support, without a strengthening of standalone risk profiles”.
As a result, the gradual erosion of implicit sovereign support for senior debt represents, in a sense, a greater threat to senior unsecured debt ratings than subordination risk, the panelists at the AFME conference argued.
Macnab added: “We have moved to a BBB-rated world so by definition investors are taking on credit risk.”
Although EU policymakers have promised concerted action to structurally subordinate senior claims, Craig Abouchar, European CEO at Castle Hill Asset Management, said a political risk premium should hover over the asset class.
“The political uncertainty that exists in the market is massively underpriced by investors,” he said. “These are just bail-in proposals. The reality is they are not agreed yet. We could wake up, as was the case of Cyprus, and find out there has been some new negotiation. If you are an investor, how can you position for that?”
An unsecured bondholder’s potential recovery relative to secured creditors, by definition, only matters if a bank defaults. However, recent events suggest it is a game of second-guessing regulators, rather than analyzing credit fundamentals.
Simon Martin, director at BlackRock, said: “Debt at the senior level in small institutions will ultimately become more risky. But there will be ambiguity for investors on whether anyone is really going to press the button over systemic institutions. There will continue to be this expectation gap between what investors think and what regulators think.”
The complex nature of credit analysis – the merging of failure and default risk in input methodologies to account for the reduction of state support, de jure depositor preference as well as working out secured creditor claims relative to unsecured holders – means recovery assumptions are harder than ever to fathom, the panelists concluded.
What’s more, many doubted the efficacy of CoCo bonds as a bail-in tool. Macnab said: “The majority of the CoCos had been issued because the regulator thought assets were under-provisioned NPLs,” rather than capital ratios deteriorating. “SNS in the Netherlands hadn’t tripped up on any capital ratios. The regulator went in and said it was under-provisioned.”
Abouchar at Castle Hill added: “This strips bare the illusion that CoCos are going to be a good [bail-in] instrument. What’s the point? If you have a CoCo, does it provide any help whatsoever? It is an issue of trust. I want to lend off cashflow not off financial statements.
“The people who lead these institutions have no idea what is going on in their balance sheets. As these institutions get bigger and bigger, you are giving more power to regulators.”
Nevertheless, although political risks and new bail-in tools have negatively impacted senior claims in the creditor hierarchy, the allocation mood was surprisingly bullish, citing, in part, ample sector-wide liquidity and easing euro break-up risks.
In the context of credit-positive balance-sheet de-risking, Macnab reckoned that credit spreads and equity valuations could continue to move inversely for “many years”.
While bail-in risks are systemic – though underpriced in the senior market – the impact of the resolution regime will be largely company-specific, through investors’ credit differentiation between banks faced with inadequate capitalization, from the perspective of a regulator’s stress-test, and a reluctance by its home regulator to bail it out, the panelists concluded.