Swap Spreads give financial crisis signs?

7 March AtoZForex, Lagos – In the past few weeks, European bank stocks, particularly equities and bonds have been hit with a panic selloff. Displaying that there are financial crisis signs, which are majorly driven by a host of reasons. Starting with the fear of an impending recession, regulator concerns and the disappointment with bank profit.

The Deutsche bank risk

These are just a few examples of potential drivers of the recent market rout. A more specific driver is the Deutsche Bank, which has been a major concern, considering that there are fears about the bank’s ability to pay the interest on a niche form of debt. This may be the actual trigger of the fear,  after the bank posted a lacklustre financial report for January. This added to fears that the bank was not liquid enough to settle its liability on a contingent convertible bond, known as “cocos”.

See also: Deutsche Börse bids on LSE during Brexit turmoil

What is a “coco”?

A coco is a tier 1 bond, which acts as a “safety valve for banks under pressure.” Cocos operate such that bondholders accept the risk that the debt may never be recouped. In exchange for this risk, they offer a higher yield than senior debt. In some cases, such bonds can even be converted to shares, but is unlikely to have much value in any situation that triggered the conversion.

Besides the financial crisis signs, Deutsche bank is currently going through the process of a makeover, in a bid to fall back on its previous status as the giant of European banking. Clearing the doubts for the risk of an imminent bailout, Deutsche bank’s capital ratio — the key measure of its stability — is more than twice that required by banking regulation.

Fundamentals of financial institutions improved

Mark Holman, chief executive and portfolio manager at TwentyFour Asset Management, and a fixed income specialist said:

“The fundamentals of financial institutions have done nothing but improve in recent years,”  given that capital ratios have risen while the cost of borrowing remains low. “The worst thing that can happen to banks is credit losses, where borrowers don’t pay back their loans, but default rates have been gradually ratcheting down over the past few years.”

In conclusion, Mr Holman opines that “buying bank debt is definitely a value trade, not a safe haven,” says Mr Holman. Also, he clarified that there is unlikely to be an immediate rebound, therefore he is sanguine about the medium-term prospects for bank debt. Since at their lowest, coco bonds remain valuable even after two missed years of interest payments, they could still be worth buying.

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