When the bank doesn't call- Deutsche and its bonds - breakingviews | Print -

This time things ARE different!!!

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Deutsche Bank decided not to use its option to call in a E1bn ($1.5bn) bond, saying that the cost of refinancing it in the market made paying back investors now uneconomical. The bond’s bid price fell to 85% of face value in the market, from 95% last week.

Deutsche is the first big bank not to call such a bond. Callable securities are usually repaid at the first opportunity, typically five years after issue, and thus carry a lower coupon than their full-term maturity profile would normally require.

There are $420bn of bank callable hybrid bonds outstanding globally, according to data provider Dealogic - a figure that includes both tier-one and tier-two capital securities.

Deutsche Bank statement

When the bank doesn't call
Considered view
18 Dec 2008 03:36

By John Foley

Deutsche Bank: Deutsche Bank has broken an unspoken promise – and wreaked havoc in the process. The German bank failed to call in a E1bn ($1.5bn) bond that investors had expected to be repaid early. In its defence, it said that the high price of debt in the market made refinancing the bond uneconomical. As far as the numbers are concerned, Deutsche’s decision is perfectly rational. But rationality won't do much to placate angry credit investors.

The bond in question was a “callable” note. Banks around the world have issued $420bn of this type of paper, according to Dealogic. Regulators count the kind Deutsche had issued as tier-two capital, a secondary measure of capital strength, based on their long maturities – typically 10 years. But investors, who expect the issuer to exercise an option to call the bond in early, usually after five years, settle for a lower rate than on normal 10-year debt.

Until now, these “trust-me” securities haven’t let investors down. Banks have always repaid their bonds early and refinanced them with new ones, even when it made more financial sense not to. But it looks like the financial disconnect got too painful. Deutsche is paying just over 4% on its controversial E1bn bond. A replacement would cost around 7% - an extra E30m a year.

Holders of such bonds now face two problems. First, prices – and carrying value – are dropping to reflect the longer maturity. The bid price on Deutsche’s bond has fallen more than 10%. Second, some holders were banking on the cash. Insurance and pension funds which need to make payouts will have to fund their liabilities another way. Some money-market funds had bought bonds which they thought were close to maturity, but now turn out to be something other than short-term debt.

Investors who get caught short have no one to blame but themselves. It was naïve to think that with bank refinancing rates at eyewatering levels, banks would go on calling in their bonds. If shareholders didn’t demand a halt to the practice, regulators – who must pre-approve every call – eventually would. Deutsche has done the right thing.

If only virtue were its own reward. On Thursday some fixed income investors were claiming they would no longer buy Deutsche securities. Others said they would even boycott issues where Deutsche was an underwriter or arranger. That's probably hot air. But Deutsche may question its decision to put economics before reputation.

john.foley@breakingviews.com

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