The Markit iTraxx Europe senior and subordinated financials indices, which are closely followed measures of the health of the European financial system, have hit all-time highs, indicating a new peak in concerns over banks’ ability to repay their own bond market debts. The senior and subordinated indices hit new highs of 3.44 percent and 5.95 percent, respectively, in trading on Thursday 24 November. Both benchmarks have doubled since early July.
During an earlier stage of the financial crisis, over the months following the default of Lehman Brothers, the senior index exceeded 2 percent and the subordinated index hit 4 percent, amid widespread fears of bank failures. Both indices then declined substantially as asset prices recovered and worldwide economic activity rebounded in response to massive government stimulus packages. However, since early 2010 the two Markit iTraxx indices have warned of a renewed rise in financial sector risk, a trend that is intimately connected with an increase probability of defaults by governments.
The Markit iTraxx Europe financials indices measure the cost of insuring, for five years and via the credit derivatives market, against the default of an equally weighted basket of 25 European financial sector companies. The senior index reflects the average cost of insuring against the default of those companies’ senior unsecured debt. Index levels are expressed in basis points per annum (100 basis points equals one percent). The iTraxx subordinated index shows the average cost of insuring against the default of the financial companies’ subordinated unsecured debt.
Unsecured debt is a catch-all term referring to any type of debt instrument that is not collateralised by a “lien” or charge on specific assets in the case of the borrower’s bankruptcy. In the case of bankruptcy, unsecured creditors have a general claim on the assets of the borrower only after pledged assets have been assigned to the secured creditors.
Investors in a basket of bonds issued by the 25 Markit iTraxx Europe financials index constituents now face a near one-in-three chance of default on riskier, subordinated debt, or a one in four chance of default on senior debt, says the index compiler.
According to Markit, current index levels imply a probability of default during the next five years of 25 percent on the senior financials index and 31 percent on the subordinated financials index. The default probabilities are calculated from current index levels and from an assumed recovery rate on individual financial companies’ bond issues. The assumed recovery rate is typically 40 percent on senior debt and 25 percent on subordinated debt.
Historically, senior unsecured debt has played a major role in financing European banks’ operations. In 2007, for example, senior debt constituted around 60 percent of banks’ issuance of bonds, with subordinated debt representing around 10 percent and covered bonds the remainder. Covered bonds are a form of secured debt, backed by assets held on banks’ balance sheets.
This year, however, senior bank debt issuance looks certain to undershoot the levels recorded in each of the last four years, while there have been few sales of subordinated bank debt. There was a three-month hiatus in senior bank debt issuance in Europe this summer, amid a resurgence of concerns about default risk among eurozone member countries. In late September the debt market reopened temporarily for a number of bank issuers from European countries that are perceived as less risky, including Germany, the Netherlands, the UK and Sweden, but not for banks from countries perceived as riskier.
For the first three quarters of 2011 covered bond issuance was running at around the levels of issuance of 2010, according to figures from Fitch Ratings and Dealogic, but this has reportedly slowed since then.