Shock of the morning wasn’t the overnight Fed rate cut to zero-ish, nor the acceleration of their Quantitative Easing programme, both of which we’d expected for some time. The shock came with this press release from Deutsche Bank explaining that they wouldn’t be calling a Lower Tier 2 (LT2) bank bond. This particular bond, a Euro 1 billion issue, was issued as a 10 year deal, but with a call date after 5 years at the bank’s option in January 2009. Historically, these LT2 issues have been called after 5 years, as if not redeemed then the coupon steps up and theroretically makes it expensive funding for the bank. In this instance the coupon moves from 3.875%, to 3 month Euribor (Euro money market rate) +88bps. This currently equates to just over 4%, so is only a minor increase in the interest cost at a time when refinancing bank debt has become extremely expensive. Subordinated Deutsche Bank credit default swaps are trading at 216 bps, so it makes total economic sense for the bank to have left this relative cheap financing outstanding – to issue a brand new LT2 bond might cost Deutsche Bank a coupon of 5.5 – 6% . Euribor +88 bps is inside where the bank could issue even senior debt.
So it made economic sense, but the market was still shellshocked. The price of the bond fell from around 96 to 90 as the market opened, and other LT2 bonds are obviously under pressure too. Many had felt that there would be a credibility issue in not calling debt at this part of the capital structure, and that it might impair a bank’s ability to issue cheaply again in the future as well as being seen as a sign of weakness. Now one of the world’s biggest banks has taken such a stance however it is likely that every other bank in the world feels able to assess the callability of their outstanding bonds on purely economic grounds (although BNP Paribas did call a LT2 issue today, perhaps before they knew the precedent that DB was setting). All LT2 bonds should therefore be assessed on a yield to maturity (YTM) basis rather than on yield to call (YTC) – in other words the spreads being offered on bank bonds were unrealistically high if quoted to those shorter call dates.
So LT2 bonds are lower this morning, but a bigger hit is likely in the even more subordinated Tier 1 (T1) market. If banks now feel no moral pressure to call the more senior Lt2 bonds, they will certainly have no compunction about letting T1 bonds extend maturity – to perpetuity if necessary. And coupled with the fact that many T1 bonds will not be able to pay coupons if the bank isn’t paying an equity dividend, many investors are going to be left holding zero coupon perpetual bonds. Bond Maths 101 – the zero coupon perpetual bond is the very worst kind of bond you can own. T1 bonds are 10-12 points lower this morning.