THE POPULAR BONDS THAT COULD TURN INTO UNPOPULAR STOCKS / THE WALL STREET JOURNAL

The Popular Bonds That Could Turn Into Unpopular Stocks

The Federal Reserve’s shift on rates has pushed investors back into a trendy debt market whose risks are unusual and badly understood

By Jon Sindreu

 

Banks are leading a double life in financial markets, as investors scoff at their equity but can’t get enough of their debt. This should spell caution for those who have piled into the gray area in-between: Bank debt that turns into equity.

After this week’s selloff, bank stocks in Europe are trading close to their lowest levels on record relative to the wider Stoxx Europe 600 index. Having failed to keep pace with the broader market rally this year, they are now down 30% over the past half-decade.

Meanwhile, investors have gobbled up bank debt. This actually makes sense: After the 2008 crisis, policy makers saddled banks with regulations and ultralow interest rates that damaged their profitability—what stock investors care about—but made them less likely to fail—the focus of debt investors.

Yet it puts European banks’ contingent convertible instruments in an ambiguous position. Also known as additional tier 1 (AT1) capital, these are bonds that turn into bank equity in certain conditions, for example, if capital buffers are eroded. The principal never has to be paid back.

Over the past five years, contingent convertibles have returned 36%, compared with 21% for European high-yield debt, according to indexes by ICE Bank of America Merrill Lynch. The Federal Reserve’s shift away from raising interest rates this year has made investors buy even more of them.


Valuing banks is already a daunting task for investors. Here, a trader blows a bubble with gum as he watches his screens on the floor of the New York Stock Exchange. Photo: Richard Drew/Associated Press


European regulators made banks sell AT1 bonds to increase their capital buffers at a time when the high premium demanded by stock investors made issuing equity unaffordable. But if adding this obscure form of debt truly cheapens banks’ funding, investors will likely be the ones paying for it.

Spain offers an example: After 2008, domestic regulators sought to bail out banks and allowed similar hybrid instruments to be sold to regular savers. The savers lost most of their money shortly after.

While buyers of AT1 debt are from Wall Street rather than Main Street, many also seem to be operating under over-optimistic assumptions, including the idea that banks will always buy back the debt at key dates—a tradition that Banco Santander recently broke.

As Colin Purdie, head of Aviva Investors’ credit team, puts it: “there is still a lot of tourists in the AT1 market that don’t have the analytical ability to understand them.”

Of course, if a swift conversion of AT1 into equity avoids a market panic during the next crisis, it could benefit issuers and investors alike. But unlike defaults in the junk-bond market, conversions remain a rarity, making it hard to quantify the associated risk and ensuring panic when a bank does get close to key triggers. The alarm in 2016 about Deutsche Bank ’sAT1 debt can attest to that.

Valuing banks is already a daunting task for investors. Buying their most complex security just adds to the risks.