Friday, December 19, 2008

Deutsche tier 2: Is a bond issuer beholden to investors to exercise a call option?

Deutsche Bank’s decision not to exercise a call on its tier 2 bonds is inciting a significant number of negative comments from investors.

FT Alphaville reports: The notes in question are €1bn worth of 3.875 per cent 2004/2014 subordinated bonds. The market had been expecting Deutsche to call these notes, at par, at the first available date - January 16. That’s what banks do with such lower Tier 2 capital notes - redeem and re-issue on a regular basis.

Or at least that’s what banks used to do. On this occasion, Deutsche is allowing the bonds to turn into floating rate notes, paying three month euribor +88bp.

Bloomberg writes: The bank’s choice “will weigh on the markets for months,” said Andreas Fink, a Frankfurt-based spokesman for the BVI German Investment and Asset Management Association, whose 92 members oversee about 1.4 trillion euros of assets. Europe’s biggest investment bank said Dec. 17 it won’t redeem 3.875 percent bonds due 2014 at their first call date next month.

My take on it is that Deutsche Bank’s action arises out of a rational economic decision. Despite a penalty mechanism that will increase its bond premiums starting from initial call date (if uncalled on said date), the increased penalty rate is still significantly lower than what it would have cost the bank to call the bonds and refinance at current market rates.

Deutsche Bank had the option to buy back the notes on Jan. 16 or pay a so-called step-up coupon of 88 basis points more than the euro interbank offered rate, or Euribor, the statement said. Three-month Euribor, a benchmark for borrowing between banks, was 3.082 percent today.

The extra yield investors demand to buy financial company bonds climbed to a record 4.83 percentage points more than government debt, according to Merrill Lynch’s European Financial Corporate Index. That compares with a spread of 1.28 percentage points at the start of the year.

Investors warn that Deutsche’s decision sets a bad precedent, and increases the likelihood that other banks would follow their example in not repaying so-called hybrid-capital bonds.

Investors claim Deutsche Bank’s decision “sets a precedent” for other banks to skip calls, analysts at Societe Generale SA in London wrote in a note to clients.

But in finessing its funding costs, Deutsche has seriously spooked the fixed income market. Is this an invitation to all other banks to avoid redemptions where ever possible? What about Tier 1 notes - are redemption conventions going to be broken there too? Should the whole market be pricing in a new level of “extension risk”?

I have a beef against investors who are questioning Deutsche Bank’s decision not to call the bonds. The bond’s terms clearly indicated that they will mature in 2014, but that the bank had the option to call it in 2009. Clearly, something is amiss if investors did not take into consideration the possibility, however, little at the time of offering, that Deutsche can decide to maintain the bonds until maturity.

Clearly, these same investors would have been perfectly happy had the situation been reversed - if Deutsche had priced the bond just before rates went down. They would have been justified in asserting that Deutsche keep its agreed rate. But now that rates have gone against the investors, meaning keeping the original agreement is now more favourable on Deutsche’s part, they still want Deutsche to exercise its call option. What rational manager would do so? After all, the call is only that, an option on Deutsche’s part.

“This is a setback for the stabilization of banking markets and is likely to increase funding costs for banks generally,” Jonathan French, the London-based spokesman for the Association of British Insurers, said in an e-mailed statement to Bloomberg News.

Not necessarily. The fact that rates are now steep for new issuers should already be indicative of the market’s current sentiment. And this is precisely the reason that Deutsche prefers to maintain its bonds at the originally agreed penalty premium rather than refinance in this market.

Investors should value securities offerings based on their intended maturity, not on their expected call date. Deutsche’s move does not add “extension risk” to the market, it merely removes the investors’ perceived “early liquidity premium”. Now I’m sure this ‘early liquidity premium’ was never considered when the bonds were originally priced, and there is equally no reason for similar instruments with upcoming call dates to now trade with ‘extension risk premiums’. Surely, investors should have seen this coming, when market rates moved significantly above Deutsche’s penalty rate.

FT Alphaville fears that: One more point: if a bank like Deutsche is finding the pain of funding acute enough here, it may only be a matter of time before bank issuers start opting for coupon deferrals to limit their outgoings further.

Now coupon deferral is a different matter. When banks start reneging on agreed-upon coupons, the market will really be in for a major battering.


Anonymous said...

Agree with your comment from a theoretical standpoint. However, in practice it seems that there was a gentleman's agreement in the market to call on time. This was to get around regulatory capital structure - and in effect meant that the prices did not take into account the possibility of non-calling. Now the bonds will have to be priced correctly and according to theory.

Rogue Economist said...

That's true. Though my understanding is that when pricing took place at the beginning, they made the prospect of a non-call penalizing for the issuer. This would have prevented the issuer (at the time) from contemplating not calling, and investors rightly believed. But rates have moved so drastically since then that even the non-call repricing originally agreed to is now more palatable by comparison. In short, my take is that the non-call rate was priced correctly (for the time it was set), but it is the market that has changed recently.