Holders of British bank bonds are worried. The cost of insuring against once-unthinkable default has soared. Investors are pricing in two related risks: that senior debt will be subordinated to deposits, and that bonds will be haircut if banks fail. It’s good that bondholders no longer expect taxpayers to bail them out. But they are ignoring phase-ins designed to delay the pain.
Credit default swap (CDS) prices on British banks almost doubled between August and October. That’s a bigger jump than for lenders in countries like Spain and Italy, even though Britain is outside the euro zone, and its sovereign CDS remain subdued.
Creditors are worried about proposals from the Independent Commission on Banking designed to remove taxpayer support from banks. The ICB wants retail banking activities to be ring-fenced, meaning riskier activities like investment banking can be more easily wound down. And if the ICB succeeds in ensuring depositors get repaid first after a collapse, even unsecured creditors of the ring-fenced entity will be pushed down the queue.
Investors have taken the proposals to heart. Lloyds’ CDS are trading like the debt of an entity with a BBB- credit rating, according to Fitch Solutions. That’s four notches below the “A” rating Fitch has given the bank. But it’s the rating the agency would give Lloyds if it did not enjoy government support. In other words, CDS investors are betting Britain won’t bail out bondholders.
The discrepancy is even greater at RBS and Barclays, which both have big investment banks. RBS’s CDS trade like default swaps of entities rated two notches below the lender’s standalone rating from Fitch. Barclays’ CDS trade as if the bank’s debt were rated five notches lower than the rating it would have if government support were removed.
Of course, CDS prices tend to react faster to events than ratings agencies, and prices are more volatile than underlying bonds. And higher CDS prices are a welcome sign that bondholders are taking reform seriously.
However, investors appear to be anticipating change sooner than is realistic. While the UK government has promised to pass legislation before 2015, the reform deadline is not until 2019. That means default swaps with a five-year life would have matured before the new regime came in. Though investors are right to be worried, they appear to have overreacted.