Bank bonds for the brave

(breakingviews.com) -- Should bank bondholders really be heading for the exits? In recent weeks the prices of some troubled banks' subordinated debt have declined sharply and the cost of insuring it against default has risen.

For example, some Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) subordinated debt has been trading, despite investment grade ratings, at around 70 cents to 85 cents on the dollar, down in some cases from an earlier range of around 90 cents and above.

At first glance, that isn't too surprising. The banks' shares, despite their ongoing rally, are still in single-digit territory. Meanwhile, their preferred shares are trading at a fraction of face value. It doesn't seem unusual that investors exposed to the next-riskiest slice of their capital structures should suffer too.

But there are two reasons why bondholders are probably secure. First, following the disastrous collapse of Lehman Brothers, the government has no desire to see another major financial institution go bust. The systemic consequences are too awful to contemplate: the chaos unleashed on counterparties could cause a series of domino-style collapses. What's more, the entire subordinated debt market, as well as potentially other credit markets, could freeze as investors asked who is next.

Second, the government has already poured a lot of money into the banks in the form of preferred or common shares. Citi and BofA have received $45 billion each. Normally, such equity would have to go up in smoke before the bondholders' recovery was threatened. After all, common and then preferred shareholders take the first losses when a company fails. And the government probably doesn't have the guts to burn its own money.

Some bondholders still fear they might suffer. One concern is that the government might simply force banks to require their lenders to take a loss - a "haircut" in the industry jargon -alongside their equity holders in the interest of sharing the pain more broadly.

While such an idea might have some theoretical appeal to policy makers, investors in senior bank debt, which get paid out before subordinated debt holders, would probably be able to argue that such a move would constitute a default.

There is a huge amount of senior debt out there. Citigroup alone has $232 billion, according to Barclays' estimates. Given so-called "cross-default" provisions that cause any failure to pay one set of lenders to trigger defaults across a range of other debt instruments, an attempt to skin just one class of bondholders could cause all hell to break loose throughout the capital structure.

This risk could be finessed with a "conservatorship", the model the government used when it took control of Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) in September. That didn't trigger a default. But it was a special case - there's no similar legal option for Citi, BofA and others.

Equally, a takeover by the Federal Deposit Insurance Corporation - a model used for the likes of Washington Mutual and IndyMac - looks implausible for such complex institutions operating in multiple jurisdictions.

But if the government will find it hard to force a haircut on bondholders, might it still be able to give them incentive to take one? For example, some bondholders are worried that, after the Obama administration's bank "stress tests" are completed in April, the administration may lean on shaky banks to swap debt for equity.

That may be less of a threat to lenders than it seems. The government tried to get GMAC, the finance business formerly controlled by General Motors, to do so in December as a prerequisite for gaining bank holding company status. But Pimco, a big bond investor, refused to play along. Despite this, the government still let GMAC become a bank. Pimco and other GMAC bondholders bet correctly that the government, having pumped billions into the Detroit carmakers, wouldn't let a finance company linked to GM collapse.

Similar games of chicken could play out if the government demanded that banks do debt-for-equity swaps. To win this game, the authorities have to be prepared to let a bank collapse. Having seen the government blink once, bondholders probably have more stomach for the next standoff.

Yes, some banks still appear to be in dire shape. And investing in bank bonds may be only for those with steely nerves. But it's not necessarily an act of madness.