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Deutsche Bank’s bonds defy lender’s malaise

As Deutsche Bank’s stock price languishes amid news of job cuts, senior management turnover and a stormy annual general meeting, the performance of the bank’s debt instruments has been resilient. But investors should keep watch on the lender’s ability to service its additional tier 1 – or CoCo – debt. 

Deutsche Bank’s latest restructuring plan – its fourth in the last three years – sparked a recent share price sell-off. The announcement, however, to cut its workforce by 7,000 and scale back its US operations in an attempt to reduce costs and restore profitability, provided some much needed clarity about its future direction1. Nevertheless, the bank’s share price is currently trading 26% lower than it was at the beginning of the year. Bond prices, however, tell a different story (see figure 1).

Figure 1: As Deutsche Bank’s share price has tumbled, its debt securities remain resilient

chart-1

Source: Bloomberg as at May 2018

Share price rattled by restructuring…

The share-price weakness also reflects the incomplete implementation of the bank’s cost-cutting strategy, instability at the senior-management level, poor communication with the market, confusion about its financial targets and the 13% decline in its future earnings during Q1.

In April, Chairman Paul Achleitner abruptly ousted CEO John Cryan two years before his contract ended, announcing that the bank needed a “new execution dynamic” in its leadership 2. Deutsche Bank has now had four CEOs or co-CEOs during the six-year tenure of Mr Achleitner. Our in-house engagement team, Hermes EOS, believes the nomination and selection process used by the bank’s supervisory board to appoint senior executives needs to be reviewed and improved3. In a recent note, Dr Hans-Christoph Hirt, Head of Hermes EOS, wrote:

“The continuing frequent departures of management board members raises the question of whether there are deficiencies in the supervisory board’s selection process of senior executives. Furthermore, we ask whether the management board changes could simply mask an underlying problem, namely, the lack of an implementable strategy that creates value for shareholders and other stakeholders.”

…As debt securities show resilience 

Debt markets, however, remain unfazed by the turbulence. As at 31 March, the bank’s common equity tier one (CET1) capital ratio was robust, at 13.7% – that’s well above 10.65%, the minimum requirement set by European Central Bank for 20184. The hard constraint for Deutsche Bank, therefore, is not the amount of capital it has, but rather its leverage exposure and the pot of distributable reserves it uses to pay the coupon on its Additional Tier 1 (AT1) bonds.

AT1 bonds – also known as contingent convertible bonds, or CoCos – are considered to be the riskiest form of debt that banks can issue: they provide capital when a lender needs it most and are converted into equity when their capital level falls below a certain threshold.

Deutsche Bank’s fully loaded leverage ratio is modest, at 3.7%. Therefore, we believe that its additional distributable items (ADI), which determine the payment of AT1 coupons, should command greater attention from investors because they amount to just €1.2bn. Notably, ADI is calculated in accordance with Germany’s GAAP law for statutory accounting and reporting requirements, which is extremely rigid. Deutsche Bank’s ADI – in absolute terms and as a percentage of the subordinated coupon payments – ranks below that of its European peers.

Moreover, this low level of ADI reduces the amount of restructuring costs that Deutsche Bank can absorb in any given year, thereby diminishing the level of change. However, given the vagaries of 2016 – when the US Department of Justice threatened the bank with a $14bn fine to settle an investigation into selling US residential mortgage-backed securities5 – management will need to tread cautiously. Otherwise, fears that reserves for paying AT1 coupons would fall short due to low ADI could arise, which in turn would weigh on the bank’s stock price, causing funding costs to increase and raising questions about the bank’s stability.

ADI ‘breathing space’

Perhaps these fears may never come to pass. Once Deutsche Bank integrates Postbank, the retail unit it had planned to sell in order to raise capital before March 2018, its ADI reserves could increase and no longer be the lender’s Achilles heel.

Although the benefit has yet to be quantified, Deutsche Bank could move the reserves for general banking risk from Postbank, which stood at €2.23bn at 31 December 2017, to its own ADI pot – a possibility recently flagged by Chief Financial Officer James von Moltke. This would subsequently provide the bank with the breathing space it needs, thereby reducing the cost of issuing new AT1 debt.

Moreover, the European Union has tabled a proposal to standardise the definitions of ADI – and the requirements for calculating them6. Such proposals, if adopted, would increase both the amount and fungibility of Deutsche Bank’s reserves, potentially providing further relief.

This document does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

  1. 1“Deutsche Bank to cut staff to well below 90,000 from current 97,000”, published by Reuters on 24 May 2018
  2. 2“Deutsche Bank picks retail specialist Christian Sewing as CEO,” published by Reuters on 8 April 2018
  3. 3During Achleitner’s six years as Chairman, there has been a high turnover on the supervisory board too, with the average tenure of these shareholder-elected members being just over two years.
  4. 4“ECB ups Deutsche’s capital requirements,” published by The Financial Times on 4 January 2018
  5. 5Deutsche Bank subsequently agreed to pay a smaller fine of $7.2bn. See: “Deutsche Bank agrees on settlement in principle with the DoJ regarding RMBS” published by Deutsche Bank as at 23 December 2016.
  6. 6“Amendments 180-414,” published by the European Parliament’s Committee on Economic and Monetary Affairs on 2 February 2018.

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