The index of reprobates: downgrades for bank bonds and the impact on the high yield market

Let me start by restating our opposition to index investing when it comes to corporate bonds (we would say that, wouldn’t we).  An equity index is an index of success – as the company prospers and its market capitalisation rises, its weighting in the index increases.  Bond indices are buckets of failure.  The more a company borrows, the greater its weighting in the bond index.  If you follow a bond index, and a company within it doubles its leverage, making its failure more likely, you will have to increase your exposure to that company.  Companies like Ford and General Motors were at one stage  23% of the European high yield market – today GM bonds trade at between 15 and 30 cents in the dollar. There is no more depressing sight in the world than a bond fund manager rejoicing in the default of a company because he or she was “underweight” the benchmark.  If you don’t like a company, or even a whole sector, don’t invest in it.  The index issue might soon become very important for high yield investors, as bank bonds continue to tumble.

We have been very clear on our views on Tier 1 bank bonds over the course of this credit crisis.  These bonds just had their worst week ever, with prices down on average around 20%.  A new Lloyds 13% Perpetual Tier 1 was issued at a price of 100 on Monday, briefly traded at a 2 point premium, before falling by 50 points by the end of the week, as nationalisation fears accelerated.  One broker held a competition to see if this was the worst performance from a corporate bond ever (the “winner” though was a high yield deal issued in the last cycle where the issuing company had a major accounting fraud discovered on the weekend after issue, although at least in this case the sponsoring investment bank made investors whole, taking the loss themselves).

RBS has just had its T1 bonds downgraded to sub-investment grade (BB+ or below).  This means that they will enter the high yield bond indices in February, and, when the rating agencies catch up with our internal ratings, there are likely to be many more bank bonds entering the high yield universe.

The European Tier 1 market has a value of Eur 40.7 billion, compared with the European High Yield market which is Eur 49.5 billion in size.  On a worst case scenario, Tier 1 could therefore become 45% of the high yield market.  This raises a lot of questions – not least, do high yield investors have the skills and appetite to invest in financial bonds (a very different animal to the usual LBO industrial and media names that are the mainstay of high yield investing).  Also, will downgrades from investment grade provoke heavy selling from funds which are not allowed to hold high yield?

So more bad news for Tier 1 – but perhaps one crumb of comfort.  The prices have fallen to such levels that for some bonds, the bank needs only to keep paying for 2 more coupons before an investor has seen a full return of capital.  Whilst full nationalisation of some banks is a step nearer, governments are making it up as they go along, and there is obviously some option value to owning subordinated bank bonds at extremely distressed levels.  Full wipe outs can still occur, but the risks are at least a bit more symmetrical at these super-distressed levels.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Categorised as: ratings banks bond categories

Discuss Article

  1. David T says:

    given the recent industry, treasury and FSA meetings and MK's announcement that he will spend £50bn somewhere in the next few weeks mean that the Tier 1 issue will more likely come to a head before the ratings agencies downgrade all T1 and UT2 bank debt?

    Posted on: 28/01/09 | 12:00 am
  2. Euan Atkinson says:

    Dear Team,

    I'm writing in reference to Jim's article, 'The index of reprobates: downgrades for bank bonds and the impact on the high yield market'  and specifically the area of Tier 1 Bank Bonds.

    Having read your blog over the last few months (which is excellent by the way!) and listened to Jim at the recent Joint Investment Forum in Glasgow I'm pretty clear on your views on this area.

    I attended an investment meeting today with a fund management group who happen to hold 45% of their bond portfolio in banks with 10% of the total portfolio in Tier 1.

    I quizzed the manager about his judgement in holding such debt in view of potential nationalisations and further downgrades.  His view was very much the spreads are huge and, if nationalised, the government would pay out on the Tier 1 bank debt due to the fact that 30% of the index is in financial bonds and half of this is in junior bonds. 

    I think his point here was that if the government didn’t honour this debt, all insurance companies would be unable to pay annuity commitments etc. 

    To me, this seems like a rather high risk approach to managing what I think people would expect to be a 'lower' risking investment fund.  I think I can probably guess your views on this but I was interested to hear what your thoughts were on this?  Is it one big gamble?

    Posted on: 28/01/09 | 12:00 am
  3. Anonymous says:

    Dear Team,

    I'm writing in reference to Jim's article, 'The index of reprobates: downgrades for bank bonds and the impact on the high yield market'  and specifically the area of Tier 1 Bank Bonds.

    Having read your blog over the last few months (which is excellent by the way!) and listened to Jim at the recent Joint Investment Forum in Glasgow I'm pretty clear on your views on this area.

    I attended an investment meeting today with a fund management group who happen to hold 45% of their bond portfolio in banks with 10% of the total portfolio in Tier 1.

    I quizzed the manager about his judgement in holding such debt in view of potential nationalisations and further downgrades.  His view was very much the spreads are huge and, if nationalised, the government would pay out on the Tier 1 bank debt due to the fact that 30% of the index is in financial bonds and half of this is in junior bonds. 

    I think his point here was that if the government didn’t honour this debt, all insurance companies would be unable to pay annuity commitments etc. 

    To me, this seems like a rather high risk approach to managing what I think people would expect to be a 'lower' risking investment fund.  I think I can probably guess your views on this but I was interested to hear what your thoughts were on this?  Is it one big gamble?

    Posted on: 28/01/09 | 12:00 am
  4. Michael Riddell says:

    Bank bonds are a very hot topic for us bond investors, since they make up such a large chunk of the index (even bigger than you suggest in fact).  They're a smaller part than they used to be and the weighting varies according to which index you look at, but in the sterling investment grade index Tier 1 and Upper Tier 2 banks are each about 6%, and Lower Tier 2 banks are 14% of the market (the weighting in subordinated bank debt is slightly lower for Europe).  Financials as a whole are just over 50% of sterling investment grade, and almost 60% of the euro investment grade market. 

    If banks are all nationalised, then what to do with Tier 1 debt clearly becomes a political decision. You've mentioned the main argument in favour of repaying Tier 1 and Upper Tier 2 investors – ie by not doing so, investors will lose even more money, be that insurance companies, pension funds etc.   If the government does choose to pay investors back in full then there could be some terrific gains for holders of these bonds bearing in mind that the average sterling Tier 1 bank bond is valued at around 50 pence in the pound, and the average euro Tier 1 bank bond is valued at more like 40 cents in the euro.  So you'd more than double your money

    Given where the market is valuing these securities, it is clearly implying that the full government rescue of Tier 1 bank bonds is very unlikely, and we concur with this.  Tier 1 bank bonds were designed as loss bearing instruments for banks in trouble, and banks are now clearly in trouble.  There are £30bn of Tier 1 bank debt in the sterling indices, and there are another few billion pounds worth that don't make it into the indices as the bond issues are too small (and therefore even less liquid).  So in a worst case scenario, it could cost the UK government more than £30bn to repay all sterling Tier 1 bank bond holders in full, and about the same again to repay all Upper Tier 2 bank bond holders.  The British government is hardly flush with cash right now and this money could be better spent.  In our view, it's much more likely that Tier 1 bank debt holders will find themselves holding equity than get all their money back.  At what point a debt for equity swap might occur – and indeed, at what point more subordinated bank debt will be downgraded to junk status by the ratings agencies – is extremely difficult to say.

    Posted on: 03/02/09 | 12:00 am

Leave a comment

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.