Deutsche Bank’s shares have touched their lowest level in more than two decades with the German lender at the centre of an intense market sell-off, reflecting concern over a looming fine from the US government.
While the bank’s balance sheet is notoriously difficult to decipher, the capital markets provide several clues as to what investors think about the future of Deutsche.
Why has share price been hit so hard?
Shares in Deutsche Bank have fallen more than 50 per cent so far this year, and were unable to hold initial gains on Tuesday, falling a further 1.3 per cent as support from bargain hunters collapsed. Investors remain convinced the bank will need to raise new capital as the Department of Justice seeks a record $14bn to settle allegations of mis-selling mortgage securities.
The issuance of equity would dilute the shareholdings of existing investors. The problem is worsened because it is difficult to see what story Deutsche can sell to prospective investors. A report by German magazine Focus said Angela Merkel had ruled out state support ahead of 2017’s elections. The bank said on Monday a capital increase is “currently not on the agenda”.
What is the market saying about the odds of state support?
One interesting aspects of capital markets surrounding Deutsche is the way they price the prospect of state support.
If a major European bank is expected to be offered state support, it is unclear how prices would react, given how many market instruments — from contingent convertible bonds (cocos) to senior unsecured bonds — are now deliberately designed to replace the need for such support. Risky bonds may be first in line for a haircut if the bank is unable to raise new capital.
The current situation has led to some unusual opportunities. Some investors, such as Axiom Alternative Investments, are short the bank’s shares but long its coco bonds. This trade has a dual benefit: if the bank is forced to issue shares, this would in principle boost bonds by protecting them from losses. It would also weaken the share price.
What are coco bonds and what are those markets telling us now?
Coco bonds — mostly referred to as additional-tier one capital — serve a simple function. Their purpose is to take losses when a bank runs into trouble and its capital falls below a certain point. As such, they are designed to help eliminate the need for taxpayers to bail out banks, as during the crisis.
Deutsche’s €1.75bn coco bond, which pays a 6 per cent coupon, fell 3.1 per cent to 73 cents on the euro on Monday. While the bond is trading at distressed levels, it is trading above the low of 71 cents it plumbed during the market turmoil of February.
There are two major risks for any investor in a coco bond. One is that the bank’s capital falls so sharply that the bonds are converted into equity or written off entirely. The other is that the bank’s capital level hits a higher point, meaning that AT1 coupon payments, along with dividends and bonuses, are halted.
The bonds are priced in such a way to imply that a missed coupon is viewed as far more probable than a writedown. Daniel Davies, of Frontline Analysts, estimates that the bank faces a tier one capital hit of €7.5bn, which, given profits and litigation reserves, would correspond to a fine of $14bn.
What about the broader coco market?
In February Deutsche helped fuel a broad market sell-off in both equity and credit. While shares have fallen this week, other banks’ coco bonds are not suffering to the same degree. For example, cocos sold by Spain’s Banco Popular traded in the low 70s in February. They are now trading at more than 90 cents on the euro and scarcely moved on yesterday’s news. UK coco bonds, despite the risks posed by the prospect of Brexit, are similarly unaffected.
In short, Deutsche is now seen as more of an outlier, subject to complicated German accounting rules and idiosyncratic litigation risks, rather than a proxy for the entire European sector.
What other markets are relevant?
As well as coco bonds, banks also sell less risky bonds, which they use to help fund their businesses. So-called “senior unsecured” bonds have not fallen dramatically in price and are generally trading in the high 90s. Like coco bonds, their prices reflect some concerns, but not the belief that Deutsche Bank is on the verge of collapse.
Investors are also buying credit-default swaps (CDS) — derivatives that offer insurance protection against senior bonds. These can also be used to hedge long positions on the bank. Deutsche Bank five-year CDS on senior bonds jumped on Monday to 250 basis points, but remain below levels seen in February and July.
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