Beware of falling rocks

The Bank of England’s controversial decision to bail out Northern Rock depositors, which was probably necessary to prevent a UK banking sector collapse, has done very little to halt the slide in Northern Rock’s equity price and for good reason. The Bank of England has been clear that its rescue is only a temporary measure, and Northern Rock’s potential to write new business and take deposits is therefore very limited, meaning that Northern Rock’s business model is no longer valid.

Financial bonds have significantly underperformed other investment grade corporate bonds over the past few months, with Tier 1 bank bonds (which are subordinated bank bonds) performing worse than single-B rated bonds during the credit sell off (click to enlarge). The average spread on UK Tier 1 bank bonds, which are rated about A- on average, is 236 basis points at the time of writing. Tier 1 banks are trading at a level you’d expect to see from a junk bond rather than a bank.

Does this mean that Tier 1 financials are now the deal of the decade? I don’t think so. All Tier 1 bonds have a call option, whereby banks have the option to buy the bonds back at a set price on a given date in the future. Although this is an ‘option’ in the literal sense, the banks have previously stated that they will call these bonds (call dates are typically 10 years after issue).

But events of the past few months mean that it’s not actually in banks’ interest to retire existing debt and reissue it, because they will be losing money in the process. Banks will still try to do everything possible to call Tier 1 bonds because the reputational risk will be extremely damaging if they turn around and show two fingers to the markets, but Northern Rock’s experience suggests that some banks may not be able to afford to refinance these bonds. And if one large bank elects not to call Tier 1 bonds, and is not punished excessively by the market, then other banks could well follow suit. Bonds that were previously thought to have maturities in 5 or 10 years could suddenly become undated, which greatly increases the risk of holding them.

The problems don’t stop there. Have a look at the chart on Northern Rock’s capital structure (which is from June, before the BofE lifeline). At the top of the capital structure sit investors in senior secured paper, who are the first in line to get paid if the company runs into trouble. Equity investors sit at the very bottom. If Northern Rock’s position deteriorates further, the bank could first of all stop paying dividends to its equity investors. After that it is allowed to stop paying dividends to preference share holders. If it stops paying dividends to pref holders, it can then renege on its interest payments to Tier 1 bond holders.

So Tier 1 bonds, which were seen as a one way bet a couple of years ago (0.8% premium for bank bonds? Fantastic!) could suddenly go from being low risk, highly rated bonds with just 5 years to maturity, to being perpetual bonds with no maturity that don’t pay any interest. Is a 2.36% premium over government bonds enough to compensate me for this not-insignificant risk? Not in my opinion.

As an aside, it’s interesting to note that debt and deposits combined form £107.7bn of Northern Rock’s capital structure, while equity makes up £1.9bn, just 1.7% of the total, as at the end of June. Some people might understandably find equities more exciting, but as the recent credit crunch has demonstrated, the importance of what goes on in the bond and money markets cannot be understated.