To assume makes an ass out of you and me, runs the old adage. Investors were reminded of this after Deutsche Bank on Wednesday broke with convention, becoming the first big bank not to exercise a call option on its subordinated notes. This debt, popular among European banks, counts as lower tier two capital and is typically structured as a 10-year issue which can be called, or redeemed, after five years. There is no obligation. But such debt has previously been bought and sold on the basis that banks would exercise their right without fail.
This was not an unreasonable bet in the past. A rise in the coupon after five years, plus the amortisation of the notes’ contribution to regulatory capital, incentivises banks to call their bonds. In current markets, however, Deutsche quite reasonably would prefer to pay the still-attractive stepped-up rate of interest rather than face a costly refinancing – saving perhaps €150m. Shareholders should applaud this economic logic.
Debt investors, though, expecting to receive face value in January, are squealing. Deutsche may now call the debt quarterly, making valuation tricky. More broadly, similar securities – of which about €11bn were due to be called between this month and July – on Wednesday fell in value on worries that other banks would follow Deutsche’s lead. This type of debt has already faded in importance for banks, given an increased focus on tier one from regulators. But a further concern is that callable tier one instruments may be next, which could see investors potentially stuck holding perpetual, non-cumulative notes ad infinitum.
Banks’ reputational risk, after all, is not what it once was, while capital preservation is top priority for regulators. Investors, perhaps, should have realised that the regulatory classification of these instruments, similar to equity, suggested that the option not to call was a real one. Upended assumptions mean a subordinated debt shake-up next year.