Unsecured debt is becoming less attractive to investors because banks are having to pledge more assets as collateral for ECB loans. An increase in issuance of covered bonds, notes secured on mortgages or public-sector loans and guaranteed by the issuer, is also depleting the collateral pool.

Benchmark issuance of covered bonds in the single currency was 93.7 billion euros — almost double the sales of senior unsecured debt — in the six months through Feb. 6, after reaching 127 billion euros a year earlier, Bloomberg data show.

There are about 2.6 trillion euros of the securities outstanding, backed by about 3.5 trillion euros of prime banking assets, according to estimates by Jonathan Glionna, an analyst at Barclays Capital in London. Assets used as collateral for central bank borrowings bring the total unavailable to unsecured creditors in a default to about 4.5 trillion euros, he said.

“By putting on a lot of secured funding, you subordinate everyone else and in the end you make it harder to issue senior unsecured bonds,” said Roger Doig, an analyst at London-based Schroders Plc, which manages about $58 billion in fixed-income assets. “The ECB is between a rock and a hard place. If the LTRO money wasn't available, banks would be starting to fail.”

Taxpayer Bailouts

Governments racing to adjust the rules to favor depositors and reduce or eliminate the role of taxpayers in bailing out distressed lenders aren't helping. The changes will lower potential recoveries for unsecured creditors in a default, probably to zero, according to Glionna at Barclays Capital.

That means holders of senior unsecured debt will be pushed further down the pecking order should a bank fail, resulting in a narrowing of the yield difference between senior and subordinated bonds, he said.

The difference in the cost of insuring banks' senior and subordinated bonds against default using indexes of credit-default swaps has shrunk to 137 basis points, the lowest since August, according to CMA. The spread between the two gauges reached a record high of 256 basis points on Nov. 25.

Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

The spread in average yield between the two types of securities in the cash market is 364 basis points, matching the level at the end of October, Bank of America Merrill Lynch index data show. The difference was 481 basis points, the most since May 2009, on Dec. 31.

“Banks are pledging more and more of their assets to the ECB and to covered bond buyers,” said John Raymond, an analyst at CreditSights Inc. in London. “For senior unsecured bondholders, it all adds up to structural subordination.”

More assets will be removed from bank balance sheets in the next LTRO, after the ECB said it will accept bank loans as collateral for their borrowing.

“Asset encumbrance is already a big deal in certain jurisdictions,” said Paul Smillie, who helps oversee about $43 billion of fixed income as an analyst at Threadneedle Asset Management in London. “Claims of unsecured creditors are being pushed way down the line.”

Unsecured funding is vital to banks because of the flexibility it offers and because lenders' business models are based on charging borrowers a higher rate than they themselves pay to borrow, according to James Ferguson, chief strategist at Westhouse Securities in London.

“Senior unsecured borrowings more closely reflect the maturities of bank assets,” he said. “If banks can't raise private-sector funding at acceptable prices, the central bank has to step in.”

Bloomberg News

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