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AT gunpoint

9 February 2016 By Neil Unmack

Deutsche Bank is turning hybrid bonds from a financial regulation poster boy into a problem child.

The German lender on Feb. 8 moved to reassure investors fretting about delayed coupons on its new AT1 securities. It shouldn’t be a big deal if Deutsche Bank suspends payment on its hybrid bonds: it suspended payment of ordinary share dividends last Autumn for two years, and the new “additional Tier 1” hybrids are supposed to absorb loss while the bank is viable – that’s why they differ from hybrid forebears in 2008. Yet instead of dampening volatility, the fear of a trigger is exacerbating it.

Bank stocks have been falling due to growth fears. That eventually started to catch up with additional Tier 1 securities. Deutsche’s are particularly vulnerable because of the bank’s weak profitability, relatively low capital, and uncertainty over German AT1 accounting idiosyncrasies.

Consider Deutsche’s 6 percent perpetual bonds. In early January these yielded around 7 percent, on a 2022 expected maturity. Yet as equity prices fell, investors started to discount AT1s with equity-like yields, pushing down prices. As yields rose, the chances Deutsche might not call the bond in 2022 increased, thus extending the possible maturity and magnifying losses. Finally, renewed threat of coupon termination meant the risk of fewer near-term cashflows. What looked like a short-dated bond risked becoming a long-dated, zero coupon instrument. The price collapsed from 93 percent of par at the start of the year to 72 percent on Feb. 8.

The problem for regulators and investors alike is that all this creates a feedback loop. As AT1 prices fell, investors had few places to sell. Banks don’t like making markets in distressed debt of their peers, and Asian private banks – big buyers of high-yield securities – were on holiday on Monday. So investors sold credit default swaps. That pushed Deutsche’s senior CDS to over 270 basis points, a level not seen since the euro zone financial crisis. Yet the risk of Deutsche failing is barely comparable: its 53 billion euros of tangible book value is 40 percent higher than the 2011 figure.

The AT1 death spiral is only one small factor in the current market maelstrom. But it highlights the risks of dressing up equity as debt. Regulators hoped the new hybrids would be better at absorbing losses than the pre-crisis ones. The instruments are great at absorbing losses, but the market isn’t.

 

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