Guest Post: Senior-Sub Question On Risk: Part Two Of Three

Tyler Durden's picture

Submitted by JM

Senior-Sub Question On Risk: Part Two Of Three

If there was ever a setting where you would think risk is properly appreciated it would be in European banks.  Look at total return on senior-sub financial European financials since 2004.  On a total return basis, European senior bank debt has outperformed subordinate debt.  As a matter of fact, you’ve lost money if you own a portfolio that replicates the BarCap sub debt index going back to late 2004. 

Source:  BarCap

Question:  Why is sub such a persistent loser in times of crisis, precisely when people should be demanding compensating return for the risk?

Possible answers:

  • In light of the bailouts and liquidity provision, you can reasonably argue that the larger banks in Europe are quasi-sovereign entities.   As a result, there is no way to adequately discern the risk differential between senior and sub debt.
  • Is this an example of the foolishness of crowds? 


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Rainman's picture

Probable answer : That sneaky ass Bernank is in play there too.

1Fatboy's picture

Concur.  No doubt those banks' 'sovereignity' has well defined boundaries that stop somewhere around $855B.  Seems like that would have just a slight way of influencing events.


oogs66's picture

Because in good times you pick up a few extra bps and in bad times it costs you lots of points?

jm's picture

There does appear to be an asymmetry in investing.  Note the option smile.

But this looks instead like people systematically and consistently underestimate risk in times of stress.  Strange.



AccreditedEYE's picture

Why is sub such a persistent loser in times of crisis, precisely when people should be demanding compensating return for the risk?

Not to be a smart ass here, but... because it's lower on the capital structure. People always run up the structure in bad times. You can see in most occasions, sub outperformed on the bounce. Firms like Avenue Capital have perfected this art. Ride the junk higher and step up on the decline. It is "subordinated" debt after all.

jm's picture

These are a reinvestible indexes, not based on a point in 2004 and tracking return statically.  So as principle is returned and reinvested, sub is more risky. 

You would expect that investors as they choose between senior and sub would demand higher yield for the risk of sub debt to outperform the safety of a higher capital structure, no?

What this is saying is that investors didn't.

AccreditedEYE's picture

But the graph says "total return". So, and correct me if I'm wrong, but principal appreciation or depreciation are also factored in... no? And it depends on time. Look at the outperformance of senior vs. sub on the 3 sell offs...

jm's picture

Right. So in the face of one sell-off, then another, why didn't investors demand a return that compensated them? Remember this is reinvesting principle as you go.

This is equivalent to saying the sell-off was more intense than investors thought it would be.  Why do they consistently underestimate?

AccreditedEYE's picture

But bond investors are only "rewarded" for taking more risk by getting a higher coupon. Their principal isn't guaranteed to outperform Senior. In a centrally planned, extremely volatile world like we have had over the last 3 yrs, taking the more extreme losses during the sell offs was probably where the sub investor lost his/her performance. There's also the uber-leverage that most credit funds/ banks are buying sub with to arbitrage as well.


Raynja's picture

assuming these prices reflect bonds held to maturity, otherwise the graphs make perfect sense, i would assume that some of the subs defaulted and it is reflected in total return. people commonly assume that the added interest rate wil compenstae them for increased default risk but this is often not true.  that would explain outperformance in good times (increased spread) and underperformance in bad times (loss of principal thru default)

jm's picture

I actually thought it would compensate because of the diversification of the index across EU names, and the blue moon incidence of default in said bank debt.

If there was a good chunk of default events, then I concur.  I didn't think there were that many bank defaults.  I could be wrong.

Raynja's picture

dint do a thorough check, back of the envelope, with 90% recovery (interest and principal) at 5% interst gives 135 (not accounting for pv of either) for sub and 138.5 at 4% senior. i dont know that these assumptions mirror reality in any meaningful way but they would provide an explanation for the downward movement in price during recessions. a print of the yields or prices would be informative for throwing ideas out without accouting for uncertainty.

jm's picture

Let me think a little more about this.  As the index is capitalization weighted, I thought this was an issue of price vol and insufficient yield to compensate. 

But if there are a lot of constitutients across the credit risk spectrum, then this probably does have more to do with default behavior in the tail.

jm's picture

I think markets actually do underestimate risk because they are short-sighted or look at risk from the perspective of the rear-view mirror.

Take the example of treasuries last night.

Most posters considered that the long bond performance in the firts exmaple was due to some idiosyncratic feature.  But long dated JGBs have outperformed everything in J-space the same way, no?


Atomizer's picture

I'm going to double post tonight. Liberty post section is the next...

Today Obama Twitter'ed 'Be Quiet And Drive (Far Away)'


Back at the ranch, LaGarde had her first IMF press confession. Do watch. Just keystroke to IMF site, posted the live feed this morning.


EU-IMF Program


7 flagship initiatives


*** The New Stability and Growth Pact*** <<<READ


Lastly, their planning has been exposed time after time. All we can do is point you to the playbook of facts that you will never read until it effects your personal financial life. To make change, it takes only one mouth breather to understand the scam.


Understanding Euroland Economic Statistics - September 2004<<<<< Read



virgule's picture

Maybe (debt) markets don't behave the way theories say they should?

jm's picture

That's a reasonable answer.

disabledvet's picture

why do banks buy their nation's debt when there's a panic?  i would argue it's in the hope of being recapitalized after the proverbial "whoopsdababy."  unfortunately how this is done in the euro zone is simply unfathomable to me--and it simply isn't being done anymore by the Greek banks--so my guess would be "there is so much American money invested in Europe" since "it's like why do Americans prefer BMW's" that the EU does indeed have the most rich and powerful friends imaginable.  Having said that does not mean that God is your friend however.  I imagine he is the sort of "guy" who "witholds judgement" on these matters.  And since it would be easy in a financial sense to equate "oil priced in dollars" with "financial God" i would think the fact that there are interest rate blow outs throughout the entirety of the EU might be considered "a moral tale."  That's why John D. Rockefeller saying "God wanted me to be" the richest man on earth is truly instructive indeed.  "One may take it as a warning as well."

zorba THE GREEK's picture

 Just buy physical Au and Ag and sleep like a baby every 


Clowns on Acid's picture

Ever since repeal of Glass Stegall (thank you R. Rubin/ S. Weill/B. Clinton) it has been a exercise in conglomeration for all financial services/assets.

Creating too big to fail, creating the destruction of the currency.

Holding them accountable is the only way out. Otherwise....we get Obama  and temporary chaos. 

Peter K's picture

And the answer is: for the same reason that Greek 10yr traded a few bp above the German Bunds for how many years? When the Euroland treasury market resembles that of the Soviet Union, provided that they would have had one, what's there to be surpised about ;)

Highrev's picture

Excellent series!


ebworthen's picture


Answer:  Markets are broken.

Risk = loss

Legerdemain = gain