Financial subordinated debt: challenges and opportunities
Contingent convertible capital instruments promise attractive returns compared to traditional high yield products, but the majority of asset managers do not offer them
The financial crisis prompted many regulatory changes, especially in the capital requirements of financial institutions.
One of the goals of regulators was to create loss-absorbing instruments that could provide relief to companies when in need of capital. That function was not performed by any of the old subordinated financial bonds, in spite of their subordinated status, and taxpayers bore the brunt of bailing in distressed banks.
In response to the attitude of banks to preserve their bondholders from any losses, regulators imposed new rules and, with the grandfathering of legacy Tier 1, definitely stripped (albeit gradually) these instruments of their capital securities status. The EC declared that: “State aid must not be granted before equity, hybrid capital and subordinated debt have fully contributed to offset any losses.”
Combining their higher need to raise capital to abide to the new requirements imposed by regulators and the bondholder unfriendliness of the new instruments, banks had to come up with somehow more enticing offerings. Contingent convertible capital instruments (CoCos) were the product of this effort. After a slow start, these instruments have been growing in size. The CoCo market totals €47bn at the end of 1Q14, and it is estimated that it will reach €150bn in a couple of years.
One of the biggest charms of these instruments is superior yield. As can be seen from the two charts, they do offer very attractive returns when compared to the traditional high yield space.
Although it may seem coherent to consider these instruments as a new version of the old subordinated financial bonds, a closer look at their structure and features reveals a truly different picture: their link to the equity world is stronger than before and caution should be adopted when considering them as an alternative to traditional credit asset classes.
In the cross-border Ucits fund landscape, only a few asset managers are taking up the opportunities and challenges offered by this asset class, both because it is still small and because it requires different professional skills than plain vanilla credit.
That said, we would like to give a few hints on what to look for when assessing the quality of a manager in this field. We consider this asset class as one of a kind and devote much effort in developing appropriate tools for monitoring the evolution in regulation and in the economics of the underlying markets. Moreover, when assessing the merit of one of these vehicles, track-record is not yet long enough for any quantitative analysis to offer any valuable hints. Therefore we approach selection in this field by sticking to fundamentals.
Hence, what we look for is a long-standing experience in the European financial sector, both in equity and in credit (both investment grade and high yield). The rationale for equity experience is straightforward: from an issuer point of view, these instruments are an alternative to equity to raise regulatory capital, not an alternative to senior bonds: the manager you trust your money with should be skilled in assessing the relative convenience for the issuer (and for you) of issuing (holding) contingent convertible securities versus stocks.
Second, financial debt, both senior and subordinated, used to be in the investment grade space before the crisis, hence a high yield only manager may not have the experience you are looking for. Moreover, since there is not an homogeneous standard in issuance up to now, a well-staffed team with strong analytical skills is essential in vetting all the relevant legal information.
Third, issuers in this asset class are mainly European banks, very different from their US peers. Having a thorough knowledge and understanding of international and European regulations is not a simple extension of US expertise: it requires time and dedicated resources. This leads to a preference for European focused managers, already familiar with European regulation being adopted at different speed and in differing formats according to diverse national legal frameworks.
Silvia Tenconi, PM & Fund Analyst, Hedge Fund & Manager Selection, Eurizon Capital
