:
- Volatility to persist while we wait for the EU and the ECB.
- Details on bail-in directive circulating in the media.
- S&P takes rating action on banks following methodology change.
- Moody’s moves systemic support for subordinated debt.
The co-ordinated central bank action that took place on Wednesday sparked a big rally. However, so far, it seems to be short lived and more measures from both politicians and central banks are likely to be needed in the coming weeks. The initiative by the central banks has made access to US dollar funding cheaper for European banks. A shortage of US dollars has been a general problem as the debt crisis has caused US banks and investors to retract some of their European exposure. To some degree, the cheaper availability of US dollars should help alleviate this problem and reduce the stigma of using the facility. However, it does little to address the fundamental factors behind the debt crisis.
Credit indices are somewhat tighter on the back of this news but CDS spreads remain very elevated. Furthermore, as we approach year-end we see less and less activity in the cash market and liquidity is shallow. This amplifies volatility and if we see trading accounts or investors needing to reduce before the end of the year (e.g. due to rating actions), it could become ugly.
During the week, we have seen some broad rating actions on banks from both S&P and Moody’s. On the back of its new bank rating methodology, S&P has reviewed the largest global banks. This resulted in downgrades of the large US banks (Bank of America, JPMorgan Chase, Goldman Sachs and Citigroup). Positively, however, the large French banks retained their high ratings.
In the Nordic region, Nordea and Handelsbanken have retained their AA- rating. DnB has kept its A+ rating and Danske Bank has kept its A rating. Swedbank and SEB have been upgraded one notch to A+, while Jyske Bank has been downgraded by one notch to A-. The market impact of the rating changes should be limited but for Nordic banks we believe the actions by S&P generally underline the relative safe status of the region as the ratings have been retained.
In the primary market, we have seen a few corporate deals. Activity is getting more subdued, however, and within a week or two new issue desks are likely to be closed for the year. Generally, 2011 has been a year of low issuance of corporate bonds – senior unsecured from banks in particular. Clearly, banks would like to come back to the primary market but the ongoing debt concerns make it very difficult and thereby the issuance need increases. Hence, new issue premiums are likely to be substantial when the market reopens and we believe this is worth waiting for from an investor perspective.
Details on the bail-in directive leaked
According to Bloomberg, the European bail-in directive will grandfather debt issued before 2013 – i.e. such senior unsecured bonds would not be included the bail-in’able debt.
If this indeed proves to be the case it has several implications. First of all, it is positive for outstanding senior unsecured debt, as this is likely to continue to be supported by the governments. Second, it could imply a wave of issuance next year, as banks would rush to secure funding not subject to the bail-in provision. This, however, is contingent on the funding markets being in much better shape.
Furthermore, we believe it is mainly positive for current outstanding debt in the stronger sovereigns. This is mostly the case for the weaker banks in the strong sovereigns, as for the strong banks in strong sovereigns the ‘option’ of bail-in is more out of the money.
In the weaker sovereigns the situation is less clear as it is the sovereign itself that has lost credibility and not necessarily the banks. Hence if the sovereign debt issues are not addressed in these countries current outstanding senior unsecured bank debt is unlikely to benefit – bail-in or not.
While bail-in was a big thing a year ago, we are not so sure anymore as the crisis is currently systemic, resulting in an already distressed market for senior unsecured debt. Hence investors have already backed away from the asset class to a large degree.
Note that the actual directive has not yet been presented and may thus be different from the reports circulating in the media.
Moody's moves systemic support for sub debt
Moody’s has placed all subordinated debt ratings of banks in those European countries where the subordinated debt still incorporates some ratings uplift from government support on review for downgrade. The review will affect 87 banks in 15 countries in Europe with average potential downgrades of subordinated debt by two notches. Note that for Tier 1 bonds, the support assumptions have already largely been removed. Senior unsecured debt is not affected by the review and support is still factored in.
The greatest number of ratings to be reviewed are in Spain, Italy, Austria and France. In the Nordic region, Sweden, Norway and Finland are affected, while Denmark is not, as support has already been removed after bank failures caused losses on subordinated debt several years ago.
The reason for the review is: i) The more limited financial flexibility of many European sovereigns; and ii) The resolution frameworks (which are likely to address loss absorption of sub debt directly), being discussed by both national and supra-national authorities (European Commission, which is expected to announce its proposals shortly).
For some time, the framework within Europe has been moving in favour of imposing losses on subordinated debt holders outside of an insolvency scenario. Sovereigns can quickly change the existing legal framework and this may hurt subordinated bondholders. The review generally reflects the trade-off between the need to preserve confidence in their banking systems and the need to protect their own balance sheets. This was the case in Ireland for example.
We believe the market impact of the downgrades will be limited. Investors in sub debt are in our view already used to being able to stomach high volatility. Some forced selling may occur if bonds are downgraded to high yield. However, we believe that the investor base in bank sub debt is less likely to be constrained by ratings as the asset class has been very risky for a long time. However, if we see forced sellers it could get rather ugly as liquidity is currently very limited.