Time to rethink subordinated debt

As investors search for income globally, one asset class within the global credit universe has become increasingly shunned, yet with careful analysis potentially offers some of the most attractive future returns: subordinated debt issued by banks, insurance companies and other financial institutions that have been downgraded to high yield.

The recent travails of this asset class are easy to understand. Ratings downgrades have seen a number of existing bonds fall out of investment-grade benchmarks leading to forced selling by some investors with mandate restrictions. An ongoing risk of further downgrades has further alienated the traditional investor base for these types of bonds.

The reaction among high-yield investors has been predictable. They appear to have been reticent to take up the slack, perhaps put off by the differences in analyzing the credit quality of banks compared to traditional high-yield corporate, as well as the unfamiliar structural language included in bond documentation or volatile performance during the credit crisis.

But despite this seemingly negative picture, performance of the subordinated debt indexes, both investment grade and high yield, has outstripped other diversified credit indices, as the table below shows.

The potential opportunity is significant and has not gone unnoticed. In Europe alone, subordinated bonds included in the Merrill Lynch Global High Yield Index total $100 billion. This has risen from $30 billion a year ago. The average yield on bonds included in this index is approximately 11.3%. Compare this to a non-financial high-yield index of $912 billion which has an average yield of 6.7%.

The market for subordinated debt instruments developed in the late 1990s and offered a way for financial institutions to meet capital targets without issuing costly equity and/or diluting returns for equity shareholders. This was a benign period for subordinated debt investors who were quite happy to take the higher coupon being offered with a degree of certainty that bonds would be called at the first opportunity, redeemed at par and would receive coupons on a timely basis.

The credit crisis changed these expectations. Through 2008-2009, subordinated bond prices fell, in some cases precipitously. Some banks in an effort to preserve capital decided not to call bonds while increasing regulatory forbearance led to a small number of banks deferring coupon payments, in some cases by changing the original bond documentation, causing bonds to trade at cents in the dollar. In the case of failed banks like Lehman and the Icelandic banks, investments in subordinated were wiped out entirely.

The advent of “bail-in legislation” over the last 18 months has caused further angst amongst investors in subordinated debt. These new laws once introduced into law explicitly state that existing and new subordinated debt instruments will bear losses when banks become distressed. Combined with deteriorating fundamentals, reduced support from governments and losses, subordinated bonds have experienced significant downgrades in the past few years.

Despite enduring a challenging period, there is the prospect of solid returns in the future. The analysis focuses on a set of triggers where value can be unlocked.

First, where bonds trade at distressed levels, banks have, in many instances sought to create core capital by offering to tender for bonds, in cash, at premiums above the prevailing market price. These, so-called liability management exercises help banks boost solvency while at the same time establish a floor for prices. Banks have been willing on average to pay a premium of between 5 and 10 points over secondary prices which enables bondholders to lock in gains.

Second, banks' historic attitude to calls can often provide a signal of how they are likely to act in the future. For example, many bonds with short-dated calls can trade at a discount to par due to uncertainty over whether the bank will exercise this call. Bonds which are trading below par and where management has historically been willing to call bonds at the earliest opportunity can offer a good risk-return profile. For example, at the start of 2012, bonds issued by French bank Société Générale were trading around 85 cents then were subsequently repaid at par within three months or an annualized total return of over 75%.

Third, it is worth considering related regulatory factors that can unlock the value in subordinated debt instruments. For example, the advent of Basel III and other regulatory frameworks can often mean that existing capital securities will no longer count as regulatory capital going forward. In these cases, the likelihood of bonds being redeemed at the first call date or tendered for cash is usually greater.

New regulation often leads to the development of new debt instruments. Recently we have seen some banks issue contingent capital securities (CoCos). While a nascent asset class, investor appetite appears significant given the additional yield offered. For example, UBS recently issued $2 billion of “low-trigger” CoCos having received orders of $9 billion from more than 450 investors.

Finally, while many debate the strength of European banks, it is clear that there has been a significant improvement in key financial metrics over the last five years, most notably on capital and liquidity. Bank management can underline the improvements in balance sheets and provide confidence to investors as well as lowering funding costs by tendering for securities, including non-subordinated debt. Lloyds Banking Group's recent tender offer for senior bonds was illustrative of this, not only in providing investors with immediate upside but also in sustained spread tightening after the tender was over.

As government bond yields collapse helping drive down the cost and spread of corporate borrowing both for investment grade and high yield companies, subordinated debt can offer investors the possibility of stronger returns in future. While question marks will undoubtedly remain over the health of the banking sector, especially in Europe while the peripheral crisis drags on, subordinated debt is a sizable asset class. For investors with a strong research background who are able and willing to take the time to understand individual banks as well as dive deep into the analytics on a security by security basis, there is an opportunity here to take advantage of the potential returns on offer as part of a diversified investment portfolio or dedicated mandate.

Andrew Fraser is an investment director at Standard Life Investments.