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An opportunity in subordinated financial bonds?

28 May 2019

Discounted Perpetual Floating Rate Notes (FRNs) are legacy capital securities issued by banks and insurers under previous regulatory regimes. Atlanticomnium’s Romain Miginiac highlights the instruments’ attractive asymmetric risk / reward characteristics and outlines the key drivers that are likely to impact future performance, noting they could play an important role in mitigating interest rate risk.

What are DISCOs and CMS / CMTs?

There are two broad categories of Discounted Perpetual FRNs: Discounted Perpetuals (DISCOs) and Constant Maturity Swap (CMS) or Constant Maturity Treasury (CMT) instruments. Given there is currently close to USD 15 billion outstanding securities in issuance between DISCOs and CMS / CMTs, this asset class remains a sizeable portion of the legacy subordinated debt market.

Both DISCOs and CMS / CMT instruments share common features, both being:

  • Perpetual subordinated debt instruments issued under previous regulatory regimes
  • Floating coupons with low margins (where the spread is paid above the reference rate) – typically below 50 bps
  • Periodically callable – this could be annually or more frequently

Given low floating margins, both instruments trade at deeply discounted prices to reflect these relatively low coupons. However, DISCOs are mostly US dollar-denominated instruments that were issued by banks in the mid-1980s and are indexed to Libor, while CMS / CMTs are mainly euro-denominated instruments issued by both banks and insurers in the early to mid-2000s (with some US dollar issuance) that are indexed to 10-year swap rates or government bond yields.

Table 1: Main features of discount perpetual and select capital securities

Source: Atlanticomnium, company documents, features based on typical structures. As of March 2019. For illustrative purposes only. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.
*Regulatory recognition based on the current grandfathering regime, either non-eligible or eligible as Tier 2 post-grandfathering.

Past performance is not an indicator of future performance and current or future trends.

What are the drivers of performance?

1. Gearing to spreads and interest rates

As perpetual instruments with floating coupons and low margins, the instruments are naturally geared to rising interest rates and tightening credit spreads. Regarding the former, bondholders should benefit from rising interest rates as the coupon is reset frequently (annually or more frequently). This means the coupons of US dollar-denominated instruments have increased significantly in the last few years as a result of the Federal Reserve’s (Fed) interest rate hikes, with coupons on US dollar DISCOs rising from below 1% in 2015 to around 3% currently. Chart 1 illustrates the positive correlation between rising US interest rates and the price of DISCOs.

In terms of credit spread tightening, Discounted Perpetual FRNs have fixed margins above the reference rate and prices are therefore also driven by the attractiveness of the margin paid compared to credit spreads on subordinated debt securities. For example, when credit spreads tighten the margin of these instruments becomes relatively more attractive and increases the probability of issuers being able to refinance the bonds at lower levels. Given the low margin on the instruments and current pricing reflecting non-call expectations – extension risk and the re-pricing of these instruments to perpetuity has impacted past performance (please see article on extension risk for more detail). Chart 1 also illustrates the correlation between tightening credit spreads (using Bank AT1 Contingent Convertibles (CoCos) as a proxy) and the cash prices of DISCOs.

Chart 1: Correlation of DISCOs to higher interest rates and tighter spreads for subordinated financials

Source: Atlanticomnium, Bloomberg, data from 02.05.2014 to 06.03.2019, using the Barclays Bloomberg Global Banking AT1 CoCo Index. DISCO index is a custom index (equal weighted price index) comprised of the 29 USD-denominated DISCO securities that the investment team covers. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

2. Previous management action

Management action is a key driver of potential returns for investors in our view. Legacy capital securities are becoming increasingly inefficient from a regulatory capital perspective (we will discuss why later), which means issuers have become more active in managing and optimising their capital position. This has generally taken the form of tenders, exchanges and market purchases and has resulted in more than 30% of instruments, according to our estimates, being subject to management action. While several tenders and exchanges were transacted at distressed levels during the financial crisis, as issuers sought to boost their capital levels by repurchasing securities well below par, we have seen other repurchases at more favorable levels. The benefit for bondholders is downside risk management, as tenders and market purchases indicate prices at which management is willing to take out these instruments and therefore establish a “floor” for potential downside.

To illustrate this point, National Australia Bank (NAB) repurchased close to USD 100 million of its US dollar DISCOs in 2017 and 2018 through open market purchases (ie bonds were bought directly from the market) at prices between 70 and 95%. This provided a strong signal to investors regarding the management’s willingness to take out these bonds. In late 2018 – when DISCOs and CMS / CMTs were under pressure – NAB’s bonds experienced less downside pressure as market participants perceived there would be a reasonable chance of further purchases or an outright redemption. Several other issuers have also conducted tenders at lower levels (for example Credit Agricole tendered its legacy CMS at 78% in 2017) and we see this as a positive move as it limits downside risk far below these levels, in our view.

Chart 2: Management action can establish downside protection (NAB DISCOs)

Source: Atlanticomnium, Bloomberg, data from 06.03.2014 to 06.03.2019. DISCO index is a custom index (equal weighted price index) comprised of the 29 USD-denominated DISCO securities that the investment team covers. The example above is being provided for illustrative purposes only. The example provided was selected to assist the reader in better understanding the various trading strategies presented. It does not represent actual performance and it is not a recommendation by the portfolio managers to buy or sell the investments mentioned in the example provided.

Past performance is not an indicator of future performance and current or future trends.

Investment Case for Discounted Perpetual Floating Rate Notes

1. Regulation – catalyst for future management action

Before focusing on any upside scenarios, we believe it is important to fully understand the regulatory treatment of these instruments in order to fully appreciate the investment case behind discounted perpetual securities. Both DISCOs and CMS / CMTs were issued under previous regulatory regimes (pre-Basel III for banks and pre-Solvency II for insurance) and currently retain eligibility as capital under grandfathering provisions (in which the old rules continue to apply for a certain period of time), but are set to be phased out by January 2022 and January 2026 for banks and insurers respectively. Some bonds issued by banks will retain eligibility provided they meet all requirements under new rules – however this would be as Tier 2 capital and not Tier 1 (CMS / CMT were previously Tier 1 capital). According to company disclosures only c 50% of Discounted Perpetuals would be eligible as capital post-grandfathering. This reduces the capital efficiency of these instruments post-grandfathering as they would either be ineligible or only eligible as a weaker form of capital. This issue is further complicated by (1) upcoming changes to bank regulation and (2) rules around loss absorbing capital and resolution.

We believe the revised Capital Requirement Regulation (“CRR2”) in Europe should lead to further instruments being disqualified – especially those written under non-EU law which increases the amount of inefficient instruments from a regulatory capital perspective. Under newly implemented loss absorbing capital requirements and resolution frameworks, incremental criteria must be met for instruments to count towards meeting loss-absorbing capital requirements. Most notably, the Bank of England has commented that capital securities issued by UK banks should be issued out of the resolution entity (which would be the holding company for most large UK banks) and securities issued out of non-resolution entities would constitute an impediment to an orderly resolution. This highlights the growing regulatory pressure from regulators to clean-up banks’ capital positions with only fully eligible and new-style instruments. For DISCOs issued by UK banks this has particularly strong implications as these have mostly been issued out of non-resolution entities.

On the insurance side, all CMS / CMT instruments will lose their capital eligibility in January 2026 under the Solvency II grandfathering regime. As these become increasingly inefficient as capital there is a case for issuers to re-issue new style Tier 2 or Restricted Tier 1 as the end of the grandfathering period draws nearer. Comments from issuers support this view: Aegon indicated in its latest investor presentation that it will gradually refinance grandfathered instruments into fully eligible instruments

2. Asymmetric risk-reward for investors?

Combining the drivers of discounted perpetual performance, regulatory trends and the current deeply discounted trading levels (average 72% cash price for our sample) leads us to hold a positive view on the asset class. Here we will consider the case for potential upside and what investors should look for to mitigate potential downside.

Upside potential could come from a range of actions: (1) outright calls (these instruments are all callable at par annually or more frequently); (2) tenders; (3) exchanges into new instruments; (4) higher interest rates; or (5) tighter credit spreads. Discounted Perpetual FRNs are cheap for issuers to maintain – with margins over reference rates typically lower than 50 bps – therefore we believe catalysts are required for issuers to take action. As discussed, decreasing capital efficiency and mounting regulatory pressure are likely to be the largest drivers for potential moves. However, it can be useful to be cognisant of the past behaviour of issuers (for example, how debtholder-friendly they have been previously) as this could help determine potential upside. Such understanding of issuer behaviour is good illustration of why detailed analysis and deep understanding of issuers and instruments is so important for bond selection. Chart 3 presents an example of the upside potential for Discounted Perpetual FRNs. Nordea redeemed its EUR-denominated CMS in March 2018, leading to prices rising by close to 100% in the period leading up to this event (2016/17), as investors increasingly anticipated a call, and another 8% on the day as bonds were redeemed at par compared to previous trading levels of c 92%.

Chart 3: Upside potential (Nordea’s redemption of CMS in March 2018)

Source: Atlanticomnium, Bloomberg, data from 26.03.2013 to 26.03.2019. Nordea EUR Perpetual Floating Rate Note (Semi-annual coupon of 5 bps over the 10-year EUR swap rate). The security listed was selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The security included is not necessarily held by any portfolio and does represent any recommendation by the portfolio managers. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security.

Past performance is not an indicator of future performance and current or future trends.

Instruments are geared to tighter spreads and currently priced assuming a non-call (with significant extension risk priced in), therefore we believe there is also upside potential from positive sentiment in markets and instruments could be re-priced to call if investors sense an increased chance of instruments being taken out. Additionally, it is important to remember the floating-rate coupon of these instruments can provide further upside if interest rates increase.

In terms of downside risk, current levels are deeply discounted and therefore could be seen as being relatively attractive in our view, as well as providing asymmetric upside/downside potential as recent tender levels provide a relative “floor price”. There is also the significant upside potential of a swing towards par if any management action is announced. Floating coupons also mitigate interest rate risk and offer potential for diversification compared to traditional fixed-rate or fixed-to-floating subordinated debt instruments.

Overall, we believe Discounted Perpetual FRNs represent an attractive asset class within subordinated financial debt. We feel that the risk / reward profile of the instruments is likely to be asymmetric going forward as low cash prices, protection against rising rates and previous liability management limits downside risk. At the same time, we believe positive gearing to credit spreads and positive trends in regulation incentivising management action provides significant upside potential. Beyond the upside potential from higher prices, the floating rate structure should also continue to be an important driver of returns. In our view, these instruments also play an important role for portfolio diversification to mitigate interest rate risk and should benefit from higher interest rates compared to traditional fixed-rate securities.

Important legal information
Source: GAM unless otherwise stated.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Allocations and holdings are subject to change.
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