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Coco bonds, low rates and bank stocks

As the international banking sector enters bear market territory, we look at the risks facing the UK-focused banks
February 11, 2016

UK banking stocks fell to a 12-month low, while credit default swaps - insurance contracts against the risk of debt defaults - rocketed for lenders such as Deutsche Bank (DE:DBK) in a terrible week for the banks. The moves suggest investors are increasingly concerned about European banks' ability to service their debt amond other concerns.

Investors in contingent convertible bonds, or so-called 'coco bonds', have become jittery about the ability of banks to make their coupon payments. Coco bonds - the riskiest debt issued by banks - pay a fixed coupon, but can convert to equity or be written off when losses force a bank's capital below a certain threshold.

Hence the price falls for Deutsche Bank's coco bonds, as well as those of other European banks such as Credit Suisse and Banco Santander. Shares in Germany's biggest lender rebounded on Wednesday after the bank's chief executive, John Cryan, tried to reassure investors that the bank's capital position was "rock-solid", and speculation it might buy back some bonds.

 

UK banks were also dragged lower. Shares in Barclays (BARC) and Royal Bank of Scotland (RBS) are now down by around a third in the past 12 months, while Lloyds (LLOY) and HSBC (HSBA) have also suffered substantial price falls.

However, Investec Securities analyst Ian Gordon argues that the coco sell-off is more of a concern for banks with issuance ahead. "That's probably a greater issue for those in Europe and Standard Chartered (STAN) than UK banks, which are more advanced in coco issuance," he said.

The delay in expected interest rate rises from the US Federal Reserve has exacerbated poor sentiment towards the financial sector. The US yield curve is flattening, meaning the spread between long-term and short-term debt has tightened. This is bad news for banks because it means the normally higher rate at which they can charge interest on a long-term loan, such as a mortgage, is coming down in comparison to the interest they pay out on short-term borrowings.

Weak commodity prices have also hurt banks, which have made loans to energy companies and emerging economies, the latter particularly affecting Standard Chartered and HSBC. Another big challenge for UK banks is growing revenue in a lower-for-longer rate environment, although they are being helped out by a low level of impairments.