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See Deutsche Bank Annual Report 2014 - Credit Exposure from Derivatives

Deutsche Bank's Hybrid Bonds Are in a Death Spiral

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

The German lender moved on Monday to reassure investors worried about delayed coupons on its new AT1 securities. It should not be a big deal if Deutsche Bank suspends payment on its hybrid bonds. It suspended payment of ordinary share dividends last fall 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 damping volatility, the fear of a trigger is making it worse.

Bank stocks have been falling over 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 an expected maturity in 2022. Yet as equity prices fell, investors started to discount AT1s with equitylike yields, pushing down prices. As yields rose, the chances that 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 a smaller near-term cash flow. What looked like a short-dated bond risked becoming a long-dated, zero coupon instrument. The price fell to 72 percent of par on Monday, from 93 percent at the start of the year.

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 do not like making markets in the 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 credit default swaps to over 270 basis points, a level not seen since the eurozone 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 precrisis ones. The instruments are great at absorbing losses, but the market is not.

[Source: By Neil Unmack, The New York Times, 09Feb16]

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