Heard on the Street: The New World for Bank Debt

Holders of senior European bank debt look like they are safe—but for how long?

A new German Restructuring Act, making its way through parliament in Berlin, allows for haircuts and debt-for-equity swaps. That may be a hint of things to come for investors.

Europe's politicians don't dare force losses on holders of senior bank debt for fear of triggering a systemic crisis, but subordinated bondholders look like fair game. Some holders of Anglo Irish Bank subordinated debt have agreed to accept a loss of 80% in a restructuring, but Irish ministers have insisted that senior bank debt isn't under threat.

This is reflected in the cost of insuring European bank bonds against default.

The gap between the Markit iTraxx Europe Sub Financials index, made up of credit-default swaps on the subordinated bonds of 25 banks and insurers, and its Senior counterpart has more than doubled to 1.09 percentage points. That's the biggest gap since June 2009.

That gap may even widen in the short term, since the senior index looks mispriced.

Based on Anglo Irish's 20% recovery rate, the subordinated index is currently pricing in a 16% chance of defaults, UBS calculates. Yet assuming the same probability of default, the Senior index is discounting a recovery rate of 52.5%, which seems too pessimistic. Indeed, were the status quo of taxpayer bailouts to persist, the index should rally hard.

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Heard on the Street: The New World for Bank Debt