June 9, 2017 / 2:49 PM / 2 months ago

Sub market soul-searching begins

* Investors need to "price in a higher probability of write-down"

By Helene Durand

LONDON, June 9 (IFR) - The subordinated debt market stayed relatively sanguine in the face of the wipeout of Banco Popular's Additional Tier 1 and Tier 2 bonds this week, though the full impact of the biggest event faced by the asset class has yet to be fully digested.

"The risk of write-down in these junior securities has been underpriced," said Puneet Sharma, head of credit strategy in investment management at Zurich Insurance.

"This is a very significant event. I don't think the market is taking it as that, but I think investors need to price a higher probability of write-down."

Regulators' decision to effectively treat all of Popular's subordinated debt equally came as a surprise to some in the market and showed that in distressed situations, all capital is fair game.

"Wiping out the Tier 2 definitely makes you understand what subordination means," said Matthew Rees, a portfolio manager at Legal & General Investment Management.

"If a bank is in trouble, you need to work your way through the capital stack. There should be an element of decompression between where the weaker and stronger banks' subordinated debt trades as people are reminded of the risk and we have a more muscular ECB and SRB [Single Resolution Board]."

Some of this decompression was in evidence this week with some of Spain's smaller lenders subordinated debt dropping by multiple price points, while instruments issued by stronger banks remained largely unaffected.

The €300m 10 non-call five-year Tier 2 issued by Banco de Credito Social Cooperativo (the parent of Cajamar) lost 10 points over the week. It was quoted at a 90 cash price on Friday, according to Tradeweb.

Liberbank's €300m 10NC5, which priced in March, had dropped to 85.4 on Friday, over 18 points lower than where it was on Tuesday.

THE KNOWN UNKNOWN

But it is not just the pricing of Europe's smaller lenders' debt that is likely to be impacted. Investors will have to reassess the risk of regulatory intervention and how to price it while the various triggers and features that were included in bank capital instruments to appease investors appeared meaningless.

"When approaching the point of non-viability, it doesn't matter whether the instruments are high or low strike," said Filippo Alloatti, a credit analyst at Hermes Investment Management.

"When a bank is in a difficult situation and has no access to the public market, it doesn't matter what the common equity tier 1 is."

For Popular, like other banks during the financial crisis, it was liquidity that proved to be the Spanish lender's downfall while its equity ratio looked relatively solid. And AT1 debt, which is meant to act as so-called "going-concern" capital, failed to fulfil that role.

"After all the regulatory efforts to design AT1s as a form of capital that can absorb losses early on, Popular AT1s never missed a single coupon," analysts at BNP Paribas wrote.

And while Popular's senior debt was left unscathed, market participants questioned what would have happened if the lender had started to build a cushion of senior loss-absorbing debt as required under new global and European rules.

"With the new type of senior non-preferred, holdco debt, next time around, I am not sure that senior debt will be spared and that part of the market should be more cognisant of that risk," said Sharma. (Reporting by Helene Durand, Editing by Matthew Davies)

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