Bank Bonds

A Warning from the ECB

Investors don't appear to be listening -- to their peril.
Photographer: Krisztian Bocsi/Bloomberg

For a central banker, nothing beats a (non) decision on interest rates as a way to bury some bad news.

Amid the excitement of last week's meeting of the European Central Bank, the regulator slipped out some unwelcome changes to its rule-book: banks will no longer be able to use some senior unsecured bonds as collateral when getting funding from the ECB.

The move underscores a message that has been ignored by many investors. The ECB wants to distance itself from its role as lender-of-last resort to the region's banks, putting the risk on bond investors alone. Yet you wouldn't know it from looking at the spreads.

Crazy For Yield

The relative scarcity of senior preferred debt has dragged in credit spreads across financials

Source: Markit, Bloomberg

Senior, non-preferred Tier 3 bonds were introduced last year as an extra layer in the bank capital structure. As they are eligible to be bailed in, they are subordinate to existing so-called preferred senior unsecured debt, which ranks equal to the operating liabilities of a bank.

Changing Shape

Tier 3 non-preferred bonds are taking over from the traditional senior bank bond format

Source: Bloomberg

Senior isssuance includes covered bonds, and non-EU Bank total loss-absorbing capacity issuance

This latest collateral rule change shouldn't be lost on investors tempted to buy these bonds.

Put simply, there is less incentive to buy senior bank debt that can't be used in the ECB's funding system. Some of the biggest buyers of banks' bonds are other lenders, which can then park the securities at the ECB and borrow against them.

Of the 40 Tier 3 issues this year, all have tightened, bringing them even closer in to line with their senior equivalents. Spreads have widened only modestly since Thursday's announcement by the ECB, suggesting investors haven't fully factored in the implications.

Shrinking Spreads

Senior non-preferred bank bonds have outperformed other forms of bank debt

Source: Paul Cohen/Bloomberg News

Implied spreads for BNP Paribas five-year debt calculated using BVAL function.

In the long run, the ECB's decision could drive up the cost of financing, particularly for weaker lenders. By restricting some of the most senior forms of bank debt, the ECB is only nudging them to issue more expensive forms of junior debt.

Many lenders have relied on issuing senior debt for liquidity, particularly when investor appetite for subordinated debt disappeared through the EU crisis. Last week's change will shrink a haven for investors in times of stress, and could have longer-term consequences for banks' ability to easily raise capital.

The ECB and the EU Single Resolution Board are now in charge of deciding whether a bank has hit point of non-viability. It's become so hard to determine that point that bank capital has become a minefield for investors, as became sharply evident in the recent collapse of Spain's Banco Popular SA and several Italian counterparts.

Smaller non-systemically important banks haven't been required to issue Tier 3 senior non-preferred capital yet. But with new rules on minimum requirements for eligible liabilities steadily being introduced next year, the direction of travel is clear for all EU banks: senior bank capital will gradually disappear.

The result may be helpful for the ECB. For lenders, it will be expensive, and for investors a minefield.

--Gadfly's Elaine He contributed graphics.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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