21st February 2019

Danske Bank AT1: Mispriced for extension risk? | Trade Ideas

Danske Bank – The money laundering saga continues 

Danske Bank continues to be in the headlines with the ongoing money laundering scandal at its Estonian unit.   The bank’s shares have tumbled more than 50%+ in the last 12 months on uncertainty surrounding overall litigation and remedial costs.

The bank’s 2018 annual results do indicate the strength of its underlying franchise/business model and good credit profile.

In a nutshell, these are some of the numbers reported by the bank:

  • Net profit of DKK 15 billion (EUR 2 billion) translating to a ROE of 9.8%;
  • Loan loss impairment costs negative for the second year in a row reflecting strong asset quality;
  • Solid CET1 ratio of 17% and leverage ratio of 4.6%
  • Good liquidity metrics with reported LCR of 121%.

Trade Idea – Underweight the DANBNK EUR 5.75 Perp 20

I believe that the bank’s EUR AT1s (especially the 5.75 Perp 20) is misplaced for extension risks as the probability of non-call is much higher than what investors pencil in.

The bank had to recently pay up when it issued 3 year and 5 year USD Non-Preferred Senior bonds and its funding costs went up materially.  Given this, the current EUR AT1s issued by the bank, especially the bonds callable in 2020, don’t seem to be pricing in extension risks.

Currently, the DANNK 5.75 EUR Perp 20 trades around 99 cash price with the implicit expectation that the bonds may get called next year.

Though the issuer may still call the bonds given its capital situation, there is considerable uncertainty over the size of the redemial and litigation costs from settling the money laundering issues and more so if the bank is vigorously pursued for claims in the US.

Based on currently reported numbers it is unlikely that mandatory coupon suspension and writedown from a trigger event (if ECT1 drops to 7%) would come into play.

The back end reset on the bonds (if not called) is MS+464 bps and given this, my personal view is that there is a significant probability of non-call in April 2020.


Conclusion

If the bonds were to be called, investors would get paid par (so an upside of 1 point from current levels).  But if the bonds were not to be called and/or negative headlines continue to dominate, these bonds are likely to drop at least another 5 points from here.  Given this risk payoff profile, I would think investors should underweight this AT1 issue and potentially move further up the capital structure.


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GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.