Expert Commentary

Deflation Cash Hoarding Now Impacting Bond Market

There's a growing list of borrowers desperately holding on to cash.

Lloyds Banking Group Plc has joined Deutsche Bank AG and Aareal Bank AG in going against normal protocol in order to hoard cash. The British bank has become the third European bank this year to refuse to redeem an outstanding "CoCo" bond at its first call date, something that was unthinkable a few months ago. CoCo (Contingent Convertible) bonds, also called AT1s (Additional Tier 1 regulatory capital) are very risky because the investor can lose everything if the borrower fails. This is why CoCos pay a juicy interest rate and why, up until now, there has been an understanding that investors will be able to redeem the bonds at their first call date.

By refusing to redeem, Lloyds retains the cash which it says it needs to deal with "extraordinary market challenges presented by Covid-19." That's code for "we need to retain all the cash we can because we're frightened about the future," which is the quintessential psychology of deflation.

As the chart shows, credit spreads have recovered along with equity markets but are still nowhere near pre-March levels. This is a clue that credit conditions will worsen again and that the trend in cash hoarding will intensify.

Bloomberg Barclays Global Aggregate Credit Index