Pitfalls in Valuing Hybrid Bonds: Impact of Bank Bailout Regulation on Subordination Component Pricing.

Abstract

Hybrid securities combine elements of both shares and corporate bonds. A key equity-like feature of hybrid securities is the ability of the issuer to avoid making cash payments in periods of financial stress. Regarding banks as issuers, hybrid bonds may be assigned to either Additional Tier 1 (AT1) or Tier 2 (T2), provided that certain criteria are met.The objective of this research is to propose a pricing model respecting the subordination feature of T2 and AT1 hybrids. The authors undertake the challenge of finding interlinks between senior and subordinated hybrid bonds prices, using a structural approach.Empirical analysis of Banco do Brasil different bond issues characteristic and prices shows that market somehow neglects deferability of coupons and subordination of capital repayments. It results in distortion between the market price and theoretical Merton-model.Tracking down to Brasilian regulation, government policy and systemically importance of Banco do Brasil, investors concluded that government would rather proceed with bailout than let it go bankrupt or bail-in the issued debt. This enables investors to price AT1 hybrids issued by this government-owned bank rather as non-subordinated bonds. The possibility of the bailout makes the modelling of corporate debts more challenging. The authors assessed how big is the impact of the presence of the bailout on subordination component pricing.