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The squeezed middle asset class

Senior debt is under attack. Implicated in the financial crisis because of lax regulation, politicians are determined to put bondholders ahead of taxpayers in the firing line should a bank need a rescue. But the idea’s inherent political nature is one of its most maddening aspects for investors trying to quantify the new risk they face, writes Tom Porter.

Bail-in has completely changed the game of senior debt investment. Under the latest proposals to be debated in the European Parliament before the end of this year, senior bondholders could lose their money without the bank in which they are invested ever actually defaulting on its debt.

The rules are designed to protect the taxpayer, under the conviction that public money should never again bail out a private institution. Only in exceptional circumstances — such as a grave threat to wider financial stability — will European Union funds be used to prop up a failing bank. Depositor preference, protecting deposits under €100,000 from losses, is designed to protect ordinary savers, as well as preventing bank runs, and has already been used in the EU-backed rescue of Cypriot banks.

People spoke — and still speak — of a “squeezed middle class” as economic recession swept the globe in the wake of the 2008 financial crisis. Middle-income earners were forgotten, they said, as the richest were untroubled and Western governments tried to protect the low paid from austerity policies. You could forgive senior bondholders for feeling the same way.

“Senior debt is squeezed from both directions,” says Oliver Burrows, bank analyst at Rabobank in London. “It is being squeezed by bail-in from below, because losses that would normally have stopped with subordinated debt may creep into senior, and also from above by depositor preference.”

As you were?

The European Commission has set 2018 as a deadline for a bail-in law to take effect. But subordinated debt bail-in hits the market in January 2015, and there have been calls for the senior version to be hurried. When it does come into force, credit analysts will face a new risk to their positions that is virtually impossible to quantify. Even if they could predict with any accuracy that a bank would require a bail-in, there would be no way of knowing how much senior debt would be hit.

“What investors will have to do more of is analysing a bank’s liability structure,” says Simon Adamson, senior European bank analyst at CreditSights. “If you are buying senior debt you will need to look at how much is above you in terms of capital and subordinated debt as a cushion to protect you from a potential bail-in.”

Under the latest proposals, national governments will not be able to step in, or EU funds used, until at least 8% of a bank’s liabilities have been bailed in. If that level were to be used, many banks would not have enough equity capital and sub debt to cover it.

“We may see a situation where a bank’s level of subordinated debt will affect how cheaply it can fund itself in senior unsecured,” says Adamson. “Banks may issue short dated sub instruments that don’t actually count as capital, to increase that buffer for senior investors. The question will be whether the cost of the sub debt is worth the money they save on the senior.”

But for the time being, investors’ credit work has been affected little. After all, bail-in doesn’t increase the risk of a bank getting into trouble. It only increases the risk that senior bondholders will suffer losses if it does. Investors may even welcome some uniformity in bank resolution, says Burrows.

“If you do your traditional credit work, the decision to invest in senior debt hasn’t changed much,” he says. “The main change is that now there are more identifiable stages where investors will take a loss, such as the point of non-viability. Investors should take some comfort from knowing in advance where they stand if a bank runs into difficulty.”

For the better rated banks from core jurisdictions in Europe, bail-in does not pose much of a threat. Most of them are now well capitalised, and their more conservative post-crisis business models reassure investors that a rescue isn’t imminent. Plenty of them have also printed senior unsecured benchmarks this year with maturities extending well beyond any potential bail-in birth date, without paying any discernible premium.

Even a remote additional risk should have a price, and FIG bankers debate whether it is reflected by senior spreads. Some point to the fact that there is no bump in banks’ curves at 2016 or 2018 as evidence that the market hasn’t yet woken up. Others say the risk has been considered and is disguised in the overall spread.

The periphery problem

But what about those further down the credit spectrum? Only the periphery’s national champions have printed senior debt longer than five years in 2013. That is not a direct result of bail-in, say FIG syndicates, rather a refection of the steepness of second and third tier lenders’ curves. Spanish and Italian banks have stuck to the two to three year bracket in senior, and many have opted for the comparative value of covered bond funding. But whatever the reason for this strategy, investors clearly still have concerns.

“For smaller or weaker banks bail-in is more of a problem,” says Jean Raphael Crochet Jeulin, head of credit sales at Natixis. “Investors are more comfortable buying covered bonds from those banks. We have seen second tier Spanish and Italian banks do senior unsecured in the two to three year maturity this year, but they do not have the option of printing bonds that extend beyond 2018 at the moment. Bail-in will widen the spread differential between core and periphery, and between national champions and the second tier.”

The senior spreads of core and periphery banks have converged in the past 18 months, helped along in no small part by European Central Bank president Mario Draghi’s pledge to do “whatever it takes” to preserve the euro.

But that could be reversed as investors demand adequate compensation where they feel there is a genuine risk of being bailed in — a return to the haves and have-nots of the senior market that prevailed before the ECB launched its long term refinancing operations (LTRO) in late 2011.

In addition, the ECB and the European Banking Authority are about to pore over banks’ loan books in two exercises that could easily reveal more holes in balance sheets, particularly in Europe’s southern states.

“You can imagine that as a result of the ECB’s asset quality review later this year and the [EBA] stress tests next year, certain banks will be asked to raise a lot more capital,” says Roger Doig, credit analyst at Schroders. “At that point if there is a resolution situation there will be uncertainty around whether the regulator is happy to change the previous status quo and involve the senior debt. We haven’t seen that type of issuer, for example mid-size Spanish and Italian banks, do much senior this year and a lack of regulatory certainty for investors is one of the factors driving it.”

Regulatory uncertainty has plagued issuers and investors alike in the last few years. Tighter regulation was expected, and necessary, after 2008, but the source of the uncertainty has been post-crisis politics.

“The biggest unknown risk in bank credit is arguably not so much regulation in general, but the political risk inherent in that regulation,” says Rabobank’s Burrows. “Bank failures have been handled in a myriad of ad-hoc ways, and may continue to be.”

However right and proper it may be for a bank’s creditors to bear losses if it runs into difficulty, the idea of bail-in remains primarily political. Politicians seeking the support of voters are at pains to be seen not letting bank creditors walk away from failures unscathed, as they repeatedly did in the dark days of 2008 and 2009.

Regulator watch

Bail-in may be an EU-wide regime, but national regulators will have a big role in implementing it. And the problem with national regulators is that every nation has one.

“We may soon see investors making a clear distinction between banks because of their nationality, and looking very carefully at the track record of national regulators when it comes to dealing with failing banks,” says Karim Mezani, head of corporate and FIG syndicate at Natixis. “There are some regulators that will be friendlier to senior bondholders than others.”

Investors got a good look at the Netherlands’ stance in February when finance minister Jeroen Dijsselbloem said he had wanted to involve senior bondholders in the restructuring of SNS Reaal, although he eventually spared them fearing it would harm other Dutch banks’ access to senior funding.

The market may well have a better idea of what a UK-style bail-in will look like in October, when The Co-Operative Bank is set to attempt a controversial liability management exercise to convert its subordinated debt into senior bonds issued by its parent The Co-Operative Group. If the exchange fails to achieve the necessary participation, senior bondholders may be called upon to help fill the £1.5bn capital hole identified by the UK regulator.

Investors do have one thing on their side. National regulators have the reputation of their respective markets to uphold. Rough treatment of a banks’ senior investors could lead to a recalculation of the risk involved in buying the senior of the country’s other borrowers. They will also be aware that some of the biggest buyers of senior are pension funds, carrying the interests of the very people bail-in is designed to appeal to in the first place.

“If you touch senior debt you are impacting some very large asset managers like pension funds,” says Mezani. “If bail-in is required regulators will need to think carefully about the impact on the investor community, because you do not want the damage to spread. One bank in difficulty does not mean you want to put 25 asset managers in a tough situation.”

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