February 2016 – Monthly Commentary
Since the Federal Reserve ended quantitative easing in October 2014, the capital markets have become much more volatile and correlations among asset classes have risen. That condition has further intensified since the first rate hike in December. We fully expected a rise in volatility as monetary policy became less expansionary, but have been surprised by the magnitude of the change. Price action in February continued to reflect that volatility, and at one point, investors briefly feared that European banks were going to trigger a repeat of the 2008 banking crisis.
After the financial crisis, regulators were adamant that taxpayer money would not again be used to bailout a failing bank. In doing so, they shifted away from the “Too Big to Fail” mentality and replaced it with the concept of “Systemically Important Financial Institutions” (SIFI’s). Those entities that were deemed systemically important included money center banks, superregional banks, and the largest insurance companies. Being designated a SIFI subjected those financial institutions to rigorous oversight and extensive stress testing. The goal of the testing is to identify risky exposure and take steps to reduce that risk prior to a financial panic. The first and most sensible step was to increase the amount of capital held in cash and U.S. government securities, known as tier 1 capital. A higher percentage of tier 1 capital relative to total assets increases the balance sheet buffer banks maintain to ensure against loan losses. The increase also conveniently dovetailed with the explosion of debt issued by the United States, and had the added benefit of aiding the Federal Reserve in keeping interest rates low. However, despite the increased tier 1 requirement, regulators still worried that a repeat of 2008 would wipe out even a more-well capitalized balance sheet. With that in mind, they took balance sheet fortification a step further and suggested that banks issue a completely new fixed income structure dubbed contingency convertible (CoCo) bonds. Like standard bank debt, CoCo’s are issued with a fixed coupon and a final maturity, although the maturity is usually quite long, exceeding 30 years in most cases. The difference between standard bank debt and CoCo bonds is that the latter convert from debt to equity if the issuing bank’s tier 1 capital falls below a preset level, usually in the 5% to 5.5% range. Upon conversion, the liabilities of the issuing bank would immediately shrink, thereby improving the tier 1 ratio and hopefully enabling the bank to survive the crisis. The idea got a cool reception in the United States, and for good reason. Investors quickly deduced that if a bank balance sheet was under such extreme pressure as to cause its tier 1 capital to fall to 5%, then equity investors would be questioning the survivability of the bank and would likely be dumping the stock. In such a case, converting the bank debt to equity would accelerate the selling as the number of newly converted shares would flood the existing float of shares. Despite that side effect, European regulators liked the idea and pushed banks to issue CoCo debt. Yield starved investors around the globe gobbled up the CoCo’s, eager to earn the incremental yield offered by the securities. Much like the higher rated senior bank debt, the market for CoCo’s was actively traded, transparent, and moved mostly in line with senior bank debt. That is until earlier this year when worry about the solvency of European banks again intensified and the sector began to sell off. Then, in February Deutsche Bank announced an enormous quarterly loss and investor began to panic. One Deutsche Bank CoCo bond fell to a low of $70 during the month, before stabilizing just above that level. That was a price drop of nearly 25 points in less than six weeks. But selling of the debt wasn’t limited Deutsche Bank CoCo’s. Investors dumped CoCo’s of all issuers and for the first few days of the month, stock and bond market reacted as if we were on the verge of another financial crisis. Deutsche calmed market jitters by announcing that they were not at risk of triggering a contingency event and that, in fact, they would buy back outstanding senior debt in the secondary market. The market stabilized in the closing days of the month, with most of the sector recouping about a third of their price swoon. However, we wonder if that price action might be the death knell for the contingency capital fixed income market. Bond investors like stability, liquidity, and orderly price discovery and the CoCo episode demonstrated none of those qualities. At the very least, there may be a whole class of investors that will never buy a CoCo again.