Photographer: Mario Proenca/Bloomberg

Investors Aren't Very Happy With Portugal's Bank Bond Decision

A key debt concept is at risk, some say.

Pari passu, perished?

Earlier this morning, Portugal's central bank appeared to take aim at a key concept in the world of debt investing by inflicting losses on some —but not other—bank bonds. Five senior bonds worth about 2 billion euros ($2.1 billion) are being transferred from Novo Banco SA to Banco Espirito Santo SA, the bad bank that emerged from the breakup of the lender last year and which is due to be liquidated sometime in the near future. The move is meant to help recapitalize Novo Banco following a lackluster showing at the European Central Bank's stress tests.

But the transfer has also left many debt investors scratching their heads and others raging from the rooftops since the move appears to fly in the face of the pari passu (literally "equal footing") notion that demands creditors be treated equally and without preference. 

Here for instance is, Mark Holman, chief executive at TwentyFour Asset Management, a London-based investment manager that says it owns a "small amount" of some of the doomed bonds: 

We had assumed that at the point of non-viability or at the point of a capital shortfall, anything could happen - even events that we had never seen before. However we did also assume that certain protocols would be adhered to. The equal ranking language that sits in every prospectus is a core value that we never thought would be broken. However, in the event of bail in the Central Bank claims the right to change all the rules, including this one. If this is indeed the case then we can expect a great deal of legal wrangling in the future, along with increased uncertainty. It will also hinder the recovery of the good banks in the future if bond investors cannot trust the basic rules in a prospectus or the hierarchy of losses. 

CreditSights analysts led by Simon Adamson also see the potential for legal wrangling in the future, noting that "it is possible that there will be legal challenges from holders of the five bonds, on the basis they rank pari passu with the other senior bondholders, but the legal position is unclear." Indeed, they posit that one of the potential reasons the five bonds were selected for transfer is that they were issued out of the bank's Lisbon headquarters rather than out of international branches such as London (where pari passu has its own distinct legal history).

In any case, prices of the affected bonds took a nosedive this morning. Here, for example, are those notes due July 15, 2016:

EI756266 Corp (NOVO BANCO SA) Ba 2015-12-30 08-22-33
Source: Bloomberg

To further complicate matters, it appears the technicalities of the transfer mean that credit default swaps (CDS) tied to the affected bonds might not be triggered, preventing investors from recouping some of their losses through the insurance-like payments. As noted by analysts at Bespoke Investment Group, CDS on Novo Banco has actually tightened this morning, presumably in light of the strengthening of the bank's capital ratios. Everything else, however, remains a mess: "In a European market that hardly gets out of bed from the week of Christmas through the new year, this is a massive problem, with bondholders and dealers unable to mark positions due to legal uncertainty and the transferred bonds going from dollar prices in the 90s to less than 15 cents on the dollar overnight." On the plus side, CreditSights analysts add (rather dryly) that "prices on senior bonds remaining in Banco Novo should rally."

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