Does the swift rescue of Spain’s Banco Popular suggest that Europe is finally fixing its flawed banks? And do the terms of the rescue raise new risks for holders of banks’ more subordinated bonds?

The Spain Event

This week Europe’s regulators managed their fastest-ever rescue of a failing regional bank. Within just over 24 hours, they identified that Spain’s sixth-largest bank, Banco Popular, was in big trouble, took it over and sold it on to its much larger rival, Banco Santander.

The terms of the rescue deal were punitive for holders of some Popular bonds. Its most deeply subordinated Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1) bonds were wiped out entirely. And so were its higher-ranking dated subordinated Tier 2 bonds: they were converted into equity which was sold to Santander for a token €1.

Immediate Implications

Financial markets seem to have taken the Popular rescue firmly in their stride—indeed, many European bank shares and even their AT1s have been rallying. This response seems partly driven by recognition that Popular’s problems were highly idiosyncratic. Its ill-judged foray into real estate lending left it nursing a big book of problem loans. And it was concerns about these loans that drove the sharp sell-off in the bank’s shares and AT1s over the last few months.

Markets also appear to have drawn comfort from the pace and decisiveness of the regulatory response. The rescue was the first using a new EU-wide directive for managing bank failures. This particular deal was relatively easy to manage. Popular was a mid-sized, domestically focused bank and it could prove trickier to secure a similar outcome if a larger and more systemically important bank ran into trouble.

That said, it’s clear that the directive marks a welcome departure from the very ad hoc management of stressed banks that’s been the norm in Europe ever since the global financial crisis. This ad hocery is all too evident in the ongoing dawdling over recapitalizing some of Italy’s banks.

Europe’s Direction of Travel

If the Popular deal suggests Europe’s regulators are developing new determination to fix the region’s flawed banks, do the terms of that deal imply they’re getting more ruthless in their treatment of these banks’ subordinated bonds? And might this pose new—and unexpected—risks to bondholders? In our view, the wipeout of Popular’s AT1s should have come as no surprise. The highly attractive yields on offer from deeply subordinated bank debt (which often exceed the yields on corporate high-yield and emerging-market debt further up the credit hierarchy) are intended to compensate investors for the risk that their investments could get wiped out. What happened to Popular’s most subordinated bonds was specifically what was designed to happen when the bank ran into trouble.

The losses imposed on Popular’s Tier 2 bondholders are more surprising. That’s not because regulators rewrote the rules governing these bonds—rather it’s because the write-down shows regulators can stick strictly to the letter of the law even when a failing bank’s Tier 2s are owned by small retail investors. Lots of Popular’s Tier 2s were owned by smaller investors.

Overall, the terms of the Popular rescue underline the importance of fully understanding the regulatory regime governing subordinated bank bonds. Just as there are big differences between bank borrowers and their investor bases across different geographies, so there are marked differences in regional regulatory backdrops.

In general, the Popular deal confirms our view that Europe’s regulators are likely to prove much more aggressive and punitive in their treatment of bondholders when a bank fails than, for example, most of their counterparts in Asia.

What Matters Most?

We continue to believe that select European AT1 and Tier 2 bank bonds represent a highly attractive opportunity set. But we think it pays to be extremely picky before venturing down banks’ capital structures and investing in their more subordinated bonds—particularly AT1s at the bottom of the debt capital stack.

We favor a highly disciplined approach that aims to identify banks with real underlying credit strength and solid loss-absorbing buffers. Once we gain conviction on these fundamentals, we will analyze banks’ debt capital structures in detail on an expected loss basis. Our selection process involves trawling through individual bond terms and conditions, analyzing market structure and liquidity, and assessing important quantitative indicators.

This approach means our subordinated bank bond exposure in Europe is concentrated in the region’s stronger national champion banks. We steer clear of AT1s issued by the region’s weaker, generally second- and third-tier market players, like Banco Popular.

In our view, the terms of the Popular rescue confirm the merits of a consistent and scrupulous strategy when selecting the most subordinated bank bonds. This kind of strategy should be backed by in-depth research, while also integrating trading and practical portfolio implementation perspectives.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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