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Cyprus Bailout Signaling Devaluation of Subordinated Debt Swaps

Senior bank debt is being priced as the riskiest relative to junior bonds in almost six months as Cypriot plans to impose losses on higher-ranking investors roils credit markets.

Senior and subordinated measures of the Markit iTraxx Financial Index of credit-default swaps on 25 European banks and insurers have both increased for 10 of the past 12 trading days. The senior measure is rising at a faster pace, driving the ratio between them to the lowest level since September.

The Cypriot rescue marks the first time euro-region officials have forced higher-ranking bank creditors to share the burden, and investors are hedging the risk it sets a precedent. They’re also becoming concerned that junior debt insurance doesn’t cover new risks such as last month’s nationalization of Dutch lender SNS Reaal NV, which eliminated bonds that could be used to settle swaps.

“Not only are losses at a senior level becoming more likely, but sub CDS protection is likely to be rendered worthless in cases where bonds are completely converted to equity or wiped out,” said Matt King, global head of credit strategy at Citigroup Inc. in London.

The subordinated index now costs 1.6 times that for senior, down from 1.75 last month and an average of 1.7 since the measures started trading in 2004, according to data compiled by Bloomberg. The ratio may fall to 1.5 times, King said.

The senior gauge increased to 189 basis points today from 139 on March 8, while the subordinated measure rose to 306 from 236, Bloomberg data show.

A basis point on a credit-default swap contract protecting 10 million euros of debt from default for five years is equivalent to 1,000 euros a year. Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

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