Subordinated bank debt, the riskier end of the debt spectrum, may take a further hit on worries banks will miss interest payments.
Bayerische Landesbank looks set to become the first major bank to defer a coupon, or interest payment, on a Tier 1 debt issue in the credit crisis.
Subordinated debt prices have sunk in recent months on concerns that issuers will not redeem debt at the earliest maturity date, which was normal practise before the credit crisis. This is known in the market as 'extension risk'.
Unlike senior debt, the lowest ranked Tier 1 subordinated paper has far fewer rules on the payment of coupons.
The European Commission told BayernLB last week not to pay out any interest on a low-ranking Tier 1 bond as a condition for its approval of a 10 billion euro ($14 billion) capital injection from the German State of Bavaria.
"It's a big market and a lot of holders of Tier 1 have already seen huge falls. It's hard to see Tier 1 prices recovering in the near term," CreditSights analysts said in a note, commenting on BayernLB.
Analysts said that more pressure from regulators on banks to defer coupon payments was an additional worry to concerns that tighter regulation will mean longer than expected repayment dates to keep balance sheets looking healthier.
Deutsche Bank last week became the first major bank not to exercise an option to redeem a Lower Tier 2 bank bond at its earliest call date, shocking investors, and sending subordinated bank debt reeling.
Subordinated debt consists of Tier 1, Upper Tier 2 and Lower Tier 2. Tier 1 or hybrid debt is the lowest ranking tranche, with perpetual or very long maturities, and its holders are last to be paid out before shareholders.
BayernLB said it was not clear yet whether it would pay out the next annual coupon payment on its Tier 1 bond — due May 31 2009. The Commission will only allow it to pay interest if it is contractually obliged to do so, it said.
"It is too early to say. The final annual results are not yet set and we don't know if a subsidiary will pay a dividend to the parent," a spokesman said.
The parent company would contractually be obliged to pay out if the subsidiary did pay a dividend, he added.
WATCHDOGS BITE
Funding costs have risen so much that it was cheaper for Deutsche not to call the debt than to find replacement capital in spite of a penalty, Moody's said last week, adding it expects more banks to take similar action.
"This is a major event, and the market is still grappling with what it means," said one London-based banker.
Although Deutsche Bank's move was cost driven, regulators do have the final say on whether a call date should be honoured.
"Regulators have the final say on the sign-off of a call," said Mark Harmer, a credit analyst at ING. "For weaker banks that have questionable capitalisation, regulators will look favourably on non-calls."
One implication could be that some funds will now have to sell subordinated bank debt with clearer indications that it may not be called before the maturity date, the London banker said, which has put further pressure on prices.
In the case of Bayern, it is the first time that Brussels has been so specific about Tier 1 debt, said CreditSights, probably because the bank is not considered as "fundamentally sound" under state aid guidance.
It had approved state subsidies in other cases without halting debt payments because it considerd those banks "fundamentally sound", said Credit Sights, but that was not enough to ease worry in the markets.
"While this means that interest deferral on Tier 1 securities should remain rare, it does not provide the certainty that the market craves," said Adamson.
The fear that more banks would follow Deutsche's move, led to repricing of Lower Tier 2 bank debt last week, although spreads have snapped back in since then, soothed by news that BNP Paribas will call its 750 million euro ($1 billion) Lower Tier 2 debt in January, analysts said.
Standard & Poor's said last week that a more difficult operating environment will increase the risk of payment deferrals for banks' hybrid capital securities in both the United States and Europe.
Spreads on BNP Paribas' Tier 1 debt have widened by 150 to 200 basis points over the past month to around mid-swaps plus 1,000 basis points, CreditSight's Adamson said.
For Tier 1 or hybrid debt, investors had been mostly concerned that bond redemptions would be delayed rather than that banks would miss interest payments.
But with few Tier 1 bonds due to be called in 2009, that perception may now change.
