Subordinated debt: cutting edge between equity and debt

The market for subordinated debt is growing substantially. You are buying interesting opportunities as well as risks.

The Lehman crash is close to its sixth anniversary on September 15.  Investors are well prepared to take on risks again.  Promising yields are available in subordinated debt with incremental pickups against senior bonds between 100 and 400 basis points.

True bail-in instruments

As banks are required to raise the level of equity in their balance sheets they are the dominant issuers is of subordinated debt.  According to the new equity ratios “contingent convertibles” become part of the tier I ratio and as such are considered true equity. We assume that this will lead to a substantially increased new issue volume of up to Euro100 billion until the end of 2014. In Germany we are expecting Deutsche Bank, Aareal Bank and Commerzbank.

Investors should be wary of the individual trigger clauses which make them riskier than old-fashioned bonds considering them true bale-in instruments. If the core equity ratio of the bank should deteriorate you are running the risk of those CoCos to be converted into equity or their notional amount cut down to even – if needed – zero. That should stabilize the banking sector and avoid governments and taxpayers again coming to the rescue of the banks.

From 2014 onwards Merrill Lynch is supporting the market with an index for this relatively young asset segment of the CoCo-bonds namely the BofA Merrill Lynch Contingent Capital Index. The basis is the market capitalization:  60% of the index carries a high yield bond rating and 40% investment-grade with the majority rated BBB. The index currently contains 63 issues with an average yield of 5 3/4%.

Even insurers are issuing subordinated debt for instants the Vienna insurance group, Nationale Nederlanden, Intesa Sanpaolo Vita or Uniqua.

Fund managers involved in these issues are convinced that the credit quality of the issuers belonging to the financial sector has improved.  Not only the stronger regulation but also the funding side for banks have improved leading to better equity ratios and liquidity.

Know-how and diversification is crucial

Even some corporates have ventured into the subordinated segment. Telefonica, Orange to name two telecommunication companies as well as EnBW, EDF – both large utilities. Although the yield picked up versus senior bonds is not substantial, they are all worth a good look at.

The risk of subordinated bonds is that rating deterioration is causing capital losses.  You therefore need continued risk management and you better stay on top of the continuous credit monitoring.  A good fund manager does all this for you and the cost of an additional 1% looks like peanuts.