Over the past week or so we have seen an interesting development in bank bonds as around a dozen institutions across the UK and Europe have announced that they are tendering for their subordinated debt. Essentially this means they are offering to buy their bonds back from investors. Bank sub debt is usually issued with call dates (typically after 10 years) when the issuer can either repay the bonds, or extend their life and suffer an increase in the coupon rate. Banks have historically been expected to call their bonds at the first call date and there was a huge outcry in the market when Deutsche neglected to call a Lower Tier 2 bond back in December (as Jim documented here). The other extremely important feature of this type of debt is that the issuer can choose to skip coupon payments if they’re not paying an equity dividend, and this does not count as a default as it would with any other type of bond. So, firstly, tendering for the bonds makes sense from the issuers’ perspectives because it means they avoid having to decide whether to call the bond or to skip coupon payments. Although it might make sense from an economic perspective to not call the bond, and to skip interest payments, such action could potentially be very damaging to their reputation and ability to raise finance in the future. Secondly, tendering for the bonds also means they no longer have to pay out to service the debt. These two concerns are the main short-term drivers for wanting to buy back bonds with these options in them.
But what is really going on is this. Bank subordinated debt has been languishing for some time now. Banks can buy back 100p worth of their subordinated bonds at a premium to their current price to persuade investors to let them go, and yet generally only have to pay 40p to 50p in the pound (because they have been priced at 20p to 40p). And what this means in accounting terms is that, for example, cash has fallen by 40p for the bonds they buy back, and liabilities have fallen by 100p. The net result of this on capital is that the bank has a 60p ‘gain’, which goes straight into core equity, into the retained earnings account. And this is the highest quality form of capital. So investors make a small and quick profit, and the bank gets a very big boost to core capital. A further positive is that the banks can buy back Tier 1, Upper Tier 2 and Lower Tier 2, which are all different types of ‘hybrid’ capital, and get an accounting boost to core capital, which these days is the only type of capital that anyone cares about.
For the past few months there has been virtually no liquidity at all in subordinated debt. The only bonds changing hands were the cheapest, because for 10p you could buy 100p of bonds…it was basically option value. Now, though, there is at least some liquidity, and to that extent these buybacks are a positive for everyone. The news has led to a small rally in subordinated bank debt (see chart), but is not significant taken in the context of the past six months or so, during which period deeply subordinated debt has returned around -60%.
So at what prices are they offering to buy these bonds back? Well, prices vary from instrument to instrument but in all cases are significantly below par value, so those taking up the offer will be locking in substantial losses if they bought at anything other than distressed levels. By accepting 40p or 50p for their subordinated bank investments, investors are giving the banks equity (as explained above), and, although it may be happening in a different guise, this is a clear equitisation of bank capital securities, something that we recently argued was highly likely (as I wrote here). Investors seem to be willingly crystallising principal losses on their bank debt to exit the investments. From the banks’ points of view, these exchanges are the direct equivalent of buying back subordinated bonds for 40p in cash, plus the remaining 60p in equity. But in these exchanges, investors don’t even get the upside potential from the equity. Many have long been arguing Tier 1 is really worth 100p in the pound. We still don’t think it is.