value and opportunity

Warning: The securities discussed are illiquid and/or risky and the author might have bought them already before publishing the posts. Please do your own research and if you decide to invest nevertheless, use apropriate limits !!!

Background:

For readers of my blog, Depfa is no stranger. I did buy a 2015 floating tier 2 subordinated bond in 2011 and this has been a very good investment so far.

To summarize the story of Depfa for “new” readers quickly: Depfa was initially a “full service” German mortgage bank which then split up into a German mortgage bank (Aareal) and an Ireland based “public funding” bank (Depfa Plc). Shortly before the Lehman crisis, Depfa got bought by another German mortage bank, HypoRealestate (itself a spin-off from Hypovereinbsank). The rest is history: Depfa/Hyporeal Estate was the first bank to go belly up and needed to be rescued by the German Government.

After beeing rescued, the startegy was to concentrate on German Mortgage banking and to sell the old Depfa part (which has been “cleansed” from PIIGS exposure via a bad bank). The sale process seemed to have been already quite far advanced, with Leucadia as favourite, before very surprisingly the German Government pulled the sale in the last minute before closing.

Germany has intervened to prevent bailed-out bank Depfa from falling into US hands just hours before a deal was about to be struck.

The government’s financial market stabilisation fund, known as Soffin, said on Tuesday evening that Depfa should be wound down by the German authorities rather than sold for what would have been €320m to US investor Leucadia, according to people familiar with the deal.

What does that mean for Depfa bonds in general ?

Tier 1 bonds of Depfa got hit quite hard, although one must say that they enjoyed a great run up until then as this chart shows:

The reason here is I think the expectation that the FMS, which will have the task to run down Depfa, will not do anything actively with the subordinated bonds, whereas any private buyer would have tried to get the subs out as soon as possible under par in order to realize value more quickly.

Although it is not clear, how Depfa will be passed over to FMS (most likely a sale at book in my opinion, in order to facility a Hypo Real Estate sale in 2015), I think it is fair to asume that sooner or later FMS will be the owner of all assets and liabilites.

FMS itself is a Government owned “bad bank”. As bad banks need constant refinancing, FMS issues new bonds on a regular basis like this one. FMS is owned by SOFFIN, the German “bank rescue” vehicle, which itself carries an explicit Government guarantee. A good description of the FMS can be found here (in German, page 108 ff).

So once, Depfa has been transferred to FMS, in principle the liabilites should be considered FMS liabilities which again carry a AAA rating and trade more or less at levels similar to KfW.

Impact on subordinated bonds

The bloomberg article above mentioned that Depfa subordinated investors were afraid of the following:

“The main risks facing creditors now are the risk of burden-sharing as well as an indefinite coupon ban,” the analysts wrote in a note to clients on May 14. “It’s difficult to see clear upside from current levels and further volatility is likely.”

I share the opinion that it is very unlikely that coupons on Tier 1 bonds will be paid in the near future, although, at some point in time FMS might want to buy out the Tier 1 investors as well. But at current levels (50% of nominal), this is not a very attractive speculation.

However for the Tier 2 bond I own, the transfer of Depfa to the FMS is actually good news. I cannot think of any realistic scenario which would lead to a loss for the Tier 2 until maturity in 2015. If they would like to screw those bond holders, I am pretty sure they will have issues refinancing and this is the last thing they want. The LT2 bond priced consequently barely moved as we can see in the Chart:

So far, the LT2 has been a very good investment. Around 30% annualised return with, in my opinion, very little risk. If one has cash to park, I think the bond is even now a very interesting investment. You get around 5% annualized return until maturity December 2015 which is effectively Governemnt guaranteed.

I will therefore increase the position from a “half position” to a full 5% as I have plenty of liquidity in the portfolio to park.

The Depfa 2020 TRY “Kebab Zerobond” (ISIN XS0221762932)

When I started to look at Emerging markets earlier this year, especially when I looked at Koc Holding, I was surpried that Depfa had Turish Lira bonds outstanding.

When you search in Bondboard.de for TRY bonds which are traded in Germany it is even interesting to see that the 2020 Depfa TRY Zero bond is the highest yielding TRY bond available.

At a current yield of ~13% p.a., the bond trades around 4% p.a. wider than a 2 year longer EIB Zero bond and around 3% wider than similar Turkish Government (coupon) bonds.

Why does the bond look cheap ?

1. First of all, I think the problem is that the “official” rating of Depfa is BBB. Many investors will simply compare the bond with other financial BBB issues and apply respective spreads. As many of the Italian and Spanish banks are BBB as well, BBB financial spreads are high.

2. The bond is relatively small (425 mn TRY) and illiquid as the 100 K TRY denomination will deter many smaller investors (at ~47%, you need to pay around minimum 17k EUR to buy one bond). I think also, many investors prefer coupon paying bonds to zero bonds, for most investors “zero” bonds are an exotic security

3. Finally, I think not many people did like the combination of the Depfa structural risk and the TRY currency risk. Either you like Emerging markets and TRY or you want to play the Depfa capital structure, but usually not both.

However for me, the bond is the ideal combination: I do like the Depfa risk as I think that any Senior Depfa bond will be a AAA equivalent bond after the transfer to the FMS. Additionally I do also like the TRY risk. Clearly, there is downside potential and he TRY/EUR is still volatile as the chart shows:

As an investor you can gain (or loose) money with this bond based on 3 risk faktors:

A) TRY/EUR exchange rate. Based on the current interest rate differential, the market assumes that the TRY will devalue vy ~8% p.a. against the EUR.Perosnally, I see a good chance that the devaluation could be less than that. Under many metrics (PPP, BigMac index etc.) the TRY is fundamentally cheap compared to EUR and USD although there is clearly political and econimical riskimplied. The currency factor is clearly no “free lunch”.

B) Turkish interest rates. As a zerobond, the bond has a duration of ~6,5 years, i.e. if interest rates go up or down 1% the bond price will move +/-6,5%. Currently the yield curve in Turkey is flat or even inverse, with the short end slightly higher. even if long term rates stay constantand only short terms go down, one can expect some “extra juice” from the potential roll down of the bond.

C) Depfa Spread. Compared to an EIB Bond, the implicit credit spread is around 3-4% p.a. although in my eyes the credit risk is similar to an IB or german Government bond. I think there is also a good chance that this could normalize over 2-3 years. If there is some rating action following the transfer, this could even happen quicker.

All in all, I find the TRY Depfa bond very attractive and will by a half position for the portfolio. As the risk is predominantly TRY, I will allocate it to the Emerging Markets bucket.

My expectation is that I can make ~50%-60% in local currency within 3 years, if the yield curve normalizes and the Depfa Spread tightens including the normal “carry” of 13%. If half of that shows up in EUR, I will be already very happy 😉

Hedge fund edition

For a smart (hedge) fund with good access to securities lending, a long (Depfa)-short (TRY EIB 0% 2022) trade could be interesting. Despite the slight duration mismatch, this could be an interesting way to speculate on the relative spread tightening between Depfa/FMS and the EIB bonds with an interesting implicit positive carry, although I am not sure how easy it is to borrow the EB bonds.

Summary:

In my opinion, the planned transfer of the old Depfa to the FMS is good news for LT2 and Senior bonds of Depfa, as the bonds become effectively German Government equivalent. I will therefore increase my existing lT2 position up to 5% and invest a half position (2,5%) into the Depfa 2020 TRY bond as Emerging Market investment.

P.S.:Why did I call this the “Depfa Kebab bond” ?

Doner Kebab is the most popular German fast food.

Based on Turkish ingredients, the current form (with salad etc.) is supposed to be a Turkish-German invention and in my opinion a good omen that a Turkish-German combination can be really delicious…..