September 30, 2016 / 12:16 PM / a year ago

Deutsche Bank woes reopen AT1 wounds

* Bank’s riskiest bonds fall to lowest ever levels

* Coupon cover endangered by potential DoJ fine

* Broader market resists repeat of February’s free fall

By Alice Gledhill

LONDON, Sept 30 (IFR) - Deutsche Bank’s Additional Tier 1 bonds were at the heart of a savage sell-off this week, falling to their lowest ever level on Friday in the latest setback for the bank as it struggles to stem market concerns.

The AT1 bonds, the riskiest form of debt that banks can sell, have been under intense pressure since mid-September when the US Department of Justice asked Deutsche to pay US$14bn to settle an investigation into its selling of mortgage-backed securities.

The potential size of the fine has stoked fears that reserves for paying coupons on the roughly 5bn-equivalent of debt could fall short, and that Deutsche would need to seek state aid.

The bonds hit fresh lows on Friday after news broke that clients had started to pull business from the bank, just days after Deutsche said it does not need to raise extra capital and that it had not sought a government bailout.

The dire price action evoked February’s sell-off, when fears around Deutsche’s AT1 coupon cover first escalated and dragged the whole AT1 sector into a downward spiral.

There is likely to be little respite until the size of the fine is known.

“The problem here is lack of visibility, but also the extent to which Deutsche could take the rest of the AT1 market with it, as we saw at the turn of the year. For me, that’s the bigger issue. It will again take only a few big holders to throw in the towel and it could drop very quickly,” said one investor.

The fact that AT1 and equity investors track both markets exacerbates the problem, he added.

“It just becomes circular very quickly until you get to levels that are completely crazy and you see distressed money coming back. If it takes another two or three months to get more visibility on the litigation side, who knows the damage that will be inflicted on the franchise?”

Deutsche’s 1.75bn 6% AT1 callable in 2022 was bid at 69.55 on Friday morning, below the low of 70.2 during the worst of February’s sell-off. The US$1.25bn 6.25% callable in 2020 was bid at 69.8, also an all-time low. Both notes have fallen around 14 points since September 9.

BLACK BOX

The sell-off has been so brutal because the fine has greatly increased the risk of coupon deferral, which would be a first for the asset class.

To pay the coupons, which amount to around 330m, the bank must have a sufficient pool of funds known as “available distributable items”. In Deutsche’s case this was already looking slim before the fine, with matters made worse by Germany’s tricky accounting rules.

The bank assured investors in February that it had 4.3bn of ADIs for 2017, though that factored in the now delayed Hua Xia Bank stake sale. At least two coupon skips are now priced into the bonds.

“They are held to ransom by the fact that it is German GAAP accounting and there are vagaries in it that make it very difficult for us to see what’s going on, and what flexibility they have to massage the numbers or pass reserves into the ADIs,” said Steve Hussey, head of financial institutions credit research at AllianceBernstein.

WHAT A TURN OFF

But it is not just Deutsche that could turn off the coupons - the regulator also has the power to do so.

“That’s definitely a risk. The regulator could easily turn round and say you can’t pay any more dividends or coupons until you raise capital. It would be a bit of a stick to encourage the capital raise to happen,” said Robert Kendrick, a credit analyst at Schroders.

The risk of principal writedown still appears remote, however. For that to happen, Deutsche’s transitional Common Equity Tier 1 ratio would have to fall to 5.125%, giving a buffer to trigger of around 20.6bn.

“To get to where you’d take a principal hit, it’s way beyond the losses they’d go through for these settlements. (It would take) some enormous outside, one-off, overnight trading loss that brings down the whole bank,” added Hussey.

“It’s almost inconceivable they’ll get to that point.”

PROGRESS

In contrast to February, the impact on the rest of the AT1 market has been fairly contained.

“The market hasn’t reacted as it did back in February, when I think there was a little bit more misunderstanding by investors about the potential risks, and maybe now they’re being a bit more discerning and differentiating between different credits,” said AllianceBernstein’s Hussey.

The Bank of America Merrill Lynch CoCo index was yielding 5.9% on Thursday, up from 5.7% in August but well inside February’s high of 7.26%, according to Thomson Reuters data.

But the storm has stoked fresh criticism of AT1 capital, an asset class that has always divided market participants. Indeed, Deutsche’s own chief executive John Cryan decried them as a “bad product” in March.

“They’re just a pretty unhelpful instrument,” said Schroders’ Kendrick. “They don’t help much on improving the ROE or anything, they just add a huge degree of uncertainty and volatility.” (Reporting by Alice Gledhill, editing by Helene Durand, Matthew Davies, Julian Baker)

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