Until 2010 the working assumption had been that investors in senior bank bonds would remain protected, if not by the loss absorbing debt and equity holders below them, then by the government.
But this assumption was turned on its head when, in December 2010, Basel III bank resolution proposals suggested that senior debt holders could be bailed-in and forced to take a loss.
As reality began to dawn, senior investors shunned that market and instead turned to covered bonds in their droves. Through the latter half of 2011 covered bond deals came thick and fast with order books swelling to new records, as wave upon wave of credit buyers swept into the market.
This was partly because covered bonds were, and remain, excluded from bail-in. But there was, and still is, a compelling relative value argument. This is especially evident in the peripheral European markets where senior unsecured and covered bond spreads generally trade much closer to each other than in core markets.
"The spread between covered bonds and senior unsecured has become compressed in the periphery," says Kristion Mierau, senior vice president, portfolio management at Pimco in Munich. "Thus, there is uninspiring marginal compensation to go the next notch down the bank capital structures."
LTRO tilts supply to senior
But the covered bond markets dominance over senior unsecured began to fade, following the European Central Banks two long term refinancing operations conducted in December 2011 and February 2012. The financial markets were flooded with liquidity and a new pattern of demand emerged.
Issuers increasingly decided to spurn the publicly syndicated market, and opted to pledge their covered bonds to the ECB. This was mainly because the 0.5% funding provided by the central bank was many times cheaper than what would have been possible in the public market.
Also, since senior unsecured bonds could not be used for ECB repo funding purposes, issuers that had access brought publicly syndicated
"The principle is always to issue the difficult transactions if they are possible," says Julia Hoggett, managing director, head of FIG flow financing EMEA, at Bank of America Merrill Lynch in London. "Given how pricing has developed and the nature of the senior bid, issuers have seen a strong rationale to return to the senior market."
The surge of liquidity that followed the two LTROs also played a key role in flattening the credit curve and this helped boost demand for the higher yielding senior unsecured market.
"Covered bonds have become so historically rich versus senior that investors have been driven to look for yieldier alternatives from systemically important banks, from jurisdictions they are comfortable with," says Steffen Dahmer, head of covered bond syndicate at JP Morgan in Frankfurt.
The change in favour of the senior unsecured market this year has been particularly evident for banks in core jurisdictions such as Germany. And in contrast to peripheral markets, investors are rewarded for going down the capital structure.
For example, in early September Deutsche Pfandbriefbank issued a 500m three year senior deal at 195bp over mid-swaps. At the time, its five year covered bond, issued in June at mid-swaps 38bp, was indicated at around mid-swaps 12bp.
Nordic issuers, such as DNB Nor, have also enjoyed a similar situation.
"DNB is in a lucky position," says Thor Tellefsen, head of long term funding at DNB in Oslo. "The more critical investors become over some banks, the more attention the remaining banks get, and theres been so much noise in Europe it has created a lot of positive attention for the Nordic banks."
In 2011 DNB took 75% of its funding in covered versus senior, partly because it had a large unused collateral pool as it had not started issuing covered bonds until 2007. But this year DNB has funded 55% in covered bonds and 45% in senior. It has also raised some additional capital.
The improving trend in favour of senior unsecured issuance is also evident at Danske Bank. In 2011 it funded 60% in covered and 40% in senior but this year the mix has been reversed. The bank is now fully funded for 2012 and is prefunding for 2013.
But these two issuers are fortunate. For many banks in the periphery, returning to a balanced mix of funding remains out of reach. Most are overly dependent on the ECB for liquidity and covered bonds are the instrument to access that.
As a consequence of the crisis, the European market has become increasingly bifurcated. This has caused some investors to look beyond the relative value of any particular bond, the quality of collateral backing it, or even the strength of the legal framework.
In particularly challenged cases investors are increasingly taking a further step in their analysis by undertaking a fundamental examination of a borrowers long term economic viability.
"We always look at the bank first and were unlikely to buy any of its bonds if we think its business model is unsustainable," says Jozef Prokes, a portfolio manager at BlackRock.
Yet despite increasing concerns over these banks business models, Prokes is convinced the senior market has to return for them. "Unless banks move to a specialised bank model they will need senior funding," he says. "If not, they will have to rely on the ECB for funding but not even the ECB will accept every asset as collateral."
This implies that the European banking system as a whole will continue to be fragile until access to the senior market has returned for the weaker names and not just the strongest in the best regions. Furthermore, without this crucial access to senior funding, it is also questionable whether issuers would be able to sell their covered bonds over the long term.
Capital boost needed
If both senior and covered bond markets are to return for challenged names, confidence in the institutions (and their sovereigns) is absolutely crucial. This will force many issuers to boost their capital.
"Bail-in will favour solid, well capitalised banks and it will also be more difficult to fund in senior for banks that are not systemically important," says Tellefsen. "It is therefore critical that banks have a high enough capital buffer to ensure that bail-in shouldnt come into effect."
Investors, such as Claus Tofte Nielsen, a portfolio manager at Norges Bank in Oslo, hope the more challenged names will be able to increase their level of core capital and adopt more conservative business models, which, he says, should help "give comfort to unsecured senior investors after 2015".
But the issuance of hybrid and other forms of subordinate bank debt, which should theoretically provide a loss-absorbing buffer giving comfort to senior investors, may in fact complicate matters.
Tellefsen says that in the last five years he has met very few investors that have looked at the total capital ratio. "They are all occupied with core tier one ratio, regulators are focussed on core tier one. But the true part of tier one should exclude hybrids."
Other complications include the linkages between the sovereign, its local banks and the use of ECB
"The problem of banking sectors needing life support via funding mechanisms or purchasing programmes has led to concerns relating to investor subordination," says Pimcos Mierau. "The ECB LTROs exacerbate the problem by creating the incentive for banks to further monetise their balance sheets, which leaves even fewer unencumbered assets for depositors and unsecured creditors to have a claim against."
The potentially diminished senior claim of issuers that have extensively used the LTRO strengthens the case for a further capital boost to their balance sheets.
Denmark sets precedent
All banks will be obliged to move towards a more balanced funding approach in the run-up to January 2018 when bail-in will be implemented. Ultimately the finer details will be interpreted by national regulators. Many will look to Denmark for
"All financial institutions are gearing up for the adoption of regulations concerning the liquidity coverage ratio, net stable funding ratio and bail-in," says Peter Holm, head of group funding and cover pool management at Danske Bank. "Details are yet to be decided, but weve already seen a number of bank packages in Denmark and in our case bail-in is not a theoretical discussion."
When two smaller Danish banks failed in 2011, senior creditors took losses. Holm says this experience "should be taken into account by regulators". He notes that, since the introduction of the last Danish bank support package, Denmark has "not seen any senior creditor suffer a loss".
The lesson to be learnt from Denmark was that the initial bank packages, enforcing senior losses, were considered too draconian. Even though the banks concerned were very small, the Danish bank sector suffered some negative fallout as a result. But the three iterations that followed the first bank package watered down the enforcement
of bail-in, helping to improve
Covered privilege deserved
Covered bonds have been excluded from bail-in discussions due to statutory legislative protections and the structural feature of cover pools being ring-fenced from the bankruptcy estate. As such, an issuers insolvency does not necessarily trigger a covered bond event of default.
The regulatory privilege that covered bonds enjoy will probably remain intact. BlackRocks Prokes, who speaks for many other covered bond specialists, says the privilege is well deserved."The quality of covered bond legal frameworks and scrutiny on the assets that go into pools means banks are not able to abuse the system," he says. "Its also technically difficult to bail in covered bonds, as you would have to force a sale of the assets, so it is logical to exclude them from bank resolution regimes."