By Anna Hirtenstein 

Investors are betting Spanish lender Banco Santander SA won't be able to make interest payments on a risky form of bank debt. In a strange twist of events, instead of shunning the debt, investors are scooping it up.

It isn't that the bank can't afford to pay the interest. It is that the securities don't allow Santander to pay the coupon if it doesn't turn a profit this year, which it isn't expected to do. Investors are speculating that Santander will save its reputation by redeeming the securities instead of missing the coupon payments.

That bet sent the price of the securities surging 18% on Oct. 7. It closed at 91.21 cents on the euro that day, up from 77.36 cents a day earlier. On Monday, it was still trading at 91.99 cents.

"This is one of the weirdest things I've ever seen in markets: it is one for the history books," said Jerôme Legras, managing partner of Axiom Alternative Investments, which has a focus on bank capital. "Usually, a bond price will fall if a bank is perceived to have issues with paying. But in this case, it rose."

What triggered the bet was a note from Fitch Ratings on Wednesday forecasting that the Spanish lender won't be able to make the coupon payments. Fitch cut the ratings on the securities to CCC, one of its lowest tiers, suggesting that a default is imminent.

The securities don't currently pay a coupon. They offer a floating rate: The coupon is reset every six months and pays 0.05 percentage points over the 10-year euro swap rate that the debt is linked to. Many of these benchmark rates have in recent years gone subzero due to the European Central Bank's quantitative-easing programs. The coupon on Santander's bond is currently minus 0.18%, which effectively means the bank doesn't have to pay anything to the holders.

Even if that rate goes positive, Santander doesn't have to pay the coupon until it posts an annual profit again. And the bank could simply opt not to redeem the securities when it does owe a payment, which would likely send the securities' price back down.

Santander declined to comment.

This risky bet by investors shows how complex financial engineering can create unforeseen consequences for banks and their investors.

"There are still a number of old bonds which were issued at a time when nobody was even contemplating negative base rates," said Charles Poole-Warren, a capital-markets partner at law firm Allen & Overy. "But this could change in the future if it rises above zero again.

A range of rates have turned negative across Europe after central banks flooded financial markets with cheap money. That has sharply subdued the yields on the safest types of debt, including government bonds and investment-grade corporate debt. Investors are getting increasingly pushed into risky corners of the market in search of better returns.

In this case, investors know the risks they are taking. In February 2019 Santander took markets by surprise when it said it wouldn't redeem EUR1.5 billion, equivalent to $1.33 billion, of its so-called additional tier 1 bond, or AT1 debt. Until then, issuers had always redeemed the securities -- typically by their first so-called call date -- as a courtesy to investors seeking the option to sell some of the debt.

AT1 debt is considered particularly high risk because it has a perpetual maturity, leaving issuers free not to ever repay bondholders. The Santander debt that investors are betting on now also has perpetual maturity.

The bank raised EUR300 million in 2004 from the sale of the debt. The spread, or extra yield over the benchmark swap rate that the securities offered to investors tightened to 0.283 percentage points on Wednesday.

The debt's preferred status means that holders have special rights: Unless their coupons are paid, Santander can't pay dividends. The ECB has also asked commercial lenders in the eurozone to freeze dividends and share buybacks to conserve cash during the pandemic.

In July, Santander's Chairman Ana Botin said Santander is committed to paying a dividend as soon as market conditions "normalize."

The prospectus for the bond offering states that the bank can't pay a coupon to holders unless it has sufficient "distributable profits," meaning that it has to book a net profit for the fiscal year.

Santander reported a second-quarter loss of EUR11.3 billion. Its third-quarter results, due to be released on Oct. 27, will be closely scrutinized by bondholders.

The bank won't generate sufficient profit in the second half of the year to offset this loss, Cristina Torrella Fajas, an analyst at Fitch, wrote in the Oct. 7 report. That would make it Santander's first annual net loss in its 163-year history.

"Calling the bond seems to be the only solution at the moment," said Artaud Caloni, a credit portfolio manager at Meeschaert Asset Management, which holds this bond. Santander could also be back in the black by the end of the year, "meaning the bonds would be performing again. This would also be a solution, but it's not likely at the moment."

Write to Anna Hirtenstein at


(END) Dow Jones Newswires

October 12, 2020 08:05 ET (12:05 GMT)

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