Analysts warn against tier 1 bonds

Insurance companies could face a further drag on their investment portfolios if they have exposed themselves to tier 1 bonds issued by banks. Analysts are warning investors that the performance of these bonds will be weak going forward.

Roger Droig, credit analyst at Schroders, said: “Tier 1 bonds are under pressure. The Merrill Lynch Euro tier 1 index has dropped by 14% year to date (23/01/09), following a negative total return of a massive -37% in 2008. Some investors are now turning bottom fishers. Our view is that, with numerous forces lined up against tier 1 bonds, we can wait before joining them. We remain underweight.”

Tier 1 bonds have come into the spotlight as fears are growing that banks will fail to move on calling of bonds. If this happens, it could have serious implications for the holders of these bonds to meet their liabilities. “Those bonds are issued as perpetual securities but with a call typically after ten years. The question is will the banks fail to call at first call?” asked Droig.

Some financial institutions have already failed to call on these instruments. There was an uproar when Deutsche Bank failed to call a Lower tier 2 bond, which has similar call features to tier 1, in December last year.

The potential of nationalisation of banks could also have an adverse affect for tier 1 bond holders. “With the equity of the UK banks falling, investors feel the ability of the banks either to raise equity from shareholders or the government is limited. Tier 1 bondholders that are next people up in the capital structure, and they could get penalised and forced to contribute capital to the banks. If for example if the banks got nationalised they could stop paying coupons on the tier 1 debt,” says Droig.

Investors got spooked last week after analysts at Morgan Stanley also cast down on the bonds. Morgan Stanley expressed fears that US insurer Aflac could be hit by its investment in tier 1 capital bonds. Concern was growing over UK life and general insurers as well.

Aviva, which has 60% of its assets invested in corporate bonds, offered reassurances this week that its exposure to bank bonds was sound and that its portfolio was well diversified.

It is unclear by how much insurers are exposed but Droig added: “With tier one and upper tier two bonds in Sterling there is total outstanding is in the order of €60bn and of pension funds and life companies they probably own two thirds to three quarters of that.”

An additional danger to holding these instruments was that they could face potential downgrades from ratings agencies. “We saw [ratings agencies] downgrade some of the RBS bonds down to ‘junk’ and sub investment grade. That could force them [investors] to sell and suffer losses which could have an impact on investment performance.”