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Subordinated debt should work well in a rising rates environment

Monday, September 28, 2015

Interview with Gregoire Mivelaz, fixed income manager at Atlanticomnium S.A. The Geneva-based boutique manages a credit strategy for GAM. 

How are your portfolios positioned?Your portfolios mainly invest in subordinated bonds. Why are they so attractive in your opinion?

The risk of default is equally high whether one invests in senior or in junior bonds, because it relates to the company issuing the bonds. If you are convinced, because you have done your research, that a company will not go bankrupt, then it makes sense to invest in its subordinated debt, where the returns are much more attractive. It is therefore crucial for us to only invest in the highest-quality companies – those where we would also be comfortable buying their stocks. For us, this represents the best of both worlds: attractive returns from the strongest companies.

In order to get the same sorts of yields via emerging market or high-yield debt requires investors to take on much higher risks: either by further going down the rating spectrum or by buying very long-dated bonds.

Another advantage of investing in top-quality names is that these companies tend to remain strong. Companies with high market share, good management teams and solid balance sheets rarely deteriorate over a medium-term time horizon, which allows us to follow a buy-and-hold approach. This way we aim to keep trading costs low and are not forced to continuously look for new ways to invest our clients’ assets.

How willing to take risks do investors in subordinated debt have to be?

Actually, our view is that subordinated debt has proven its attractiveness over decades. It has shown its resilience over numerous business and interest rate cycles. It can be more volatile than government bonds, but even owners of government debt will have to get used to higher volatility as interest rates start to rise eventually. Interestingly, just the term ‘junior’ or ‘subordinated’ initially often has a negative connotation for investors, but really this view is very superficial and does not stand up to closer scrutiny. For us, the critical point is to only own debt of first-class issuers. We will then hold the bond typically to call date or maturity and collect the coupons. On a related point: If we like a company, we will look at the whole capital structure for investment opportunities and sometimes will invest also in its senior debt if we find it attractive.

There are additional risks for direct investors, i.e. those that do not invest via portfolios like ours. One is the prospectus risk: junior debt issuance is not standardised – each launch prospectus is different and needs very careful studying. We are talking about between 300 and 500 pages of small print. We like to compare the prospectus with the rules of a game: one can only play if you understand the rules properly. For example, the prospectus may stipulate that a company may not pay a coupon under certain circumstances. It is now crucial to understand what consequences that non-payment has: is the company obliged to pay the coupon at a later date or is it lost? These scenarios completely change the valuation of a bond.

Another problem is high minimum investments: bonds are rarely sold in lot sizes smaller than EUR 150,000, which makes reasonable diversification for the average investor unachievable. Hence, in our view it is beneficial to enter this market via a specialist manager.

Why do companies pay such high coupons for their subordinated debt?

Subordinated bonds – and also hybrid bonds, which are partly accepted as equity by rating agencies – are issued to optimise a company’s capital structure. This debt is much cheaper than equity capital but the bonds are nevertheless treated as equity. Hence, companies are willing to pay more for junior debt. Furthermore, it needs to be attractively priced as the investor base is not very large, i.e. there is less demand for junior debt, since it sits in between investment grade and high yield debt. Many institutional investors only allow investment-grade holdings, while dedicated high-yield investors do not consider debt issued by investment-grade companies.

Interestingly, the regulatory and financial advantages of hybrid bonds are now increasingly recognised by companies beyond the financial sector, which used to be the traditional issuer of that type of debt. One recent example is the German airline Lufthansa, which issued a EUR 500 million hybrid bond that offers a coupon of 5.125%. At first glance this sounds expensive, but the cost for Lufthansa to raise equity via a rights issue is much more expensive at 9.4%. On the other hand, issuing regular debt may worry banks and rating agencies. Other companies that have issued hybrids this year include EDF, Total, Volkswagen and Sainsbury.

Why does junior debt make sense in the current low-yield environment?

Interest rates are at abnormally low levels and investors struggle to obtain any positive return with government bond investments – let alone after inflation and taxes. At some point, official rates will start to rise as economies recover. The dilemma for fixed income investors is that every increase will lead to a loss of capital – irrespective of the quality of the issuer, which includes government debt. High-yielding junior bonds are much less vulnerable in this scenario, while our fixed-to-float bonds and floating rate notes will actually benefit from rising rates. This is therefore one of the few asset classes that investors can use to hedge against rising rates.

The interesting part is: conventional wisdom dictates that higher returns are only available with higher risk. But that is only true for conventional bonds, not for junior debt. As previously mentioned, the default risk for a given company is the same for both its senior as well as it junior debt.

Which are your favourite investments right now?

We believe that the financial sector offers the most opportunities due to regulatory changes. Following the global financial crisis, the Basel III regulation has made banks much safer due to increased capital requirements. Banks had to simplify their business model, shutting down risky investment banking and trading departments, and have to use more capital to underpin their remaining activities. Hence, since 2008, European banks have increased their core capital by EUR 250 billion. What is positive for us is that our legacy junior bonds, which had been issued before the crisis, are now classified as senior to this new core capital. Hence, the ongoing process of balance sheet strengthening has given our holdings a strong boost.

To give a bit more detail, we prefer legacy tier 1 bonds within the banking sector. The reason is that these need to be replaced by the banks under the Basel III rules with new subordinated paper called ‘AT1 contingent convertibles’. That process needs to be completed by January 2022. Our bonds should therefore continue to benefit from this trend for several more years. They also benefit from their increasing scarcity: there are no new bonds like these issued any more, while banks buy some of the outstanding ones back at below par, but at a premium to current market prices. With yields being still around three times higher compared to senior bonds, our aim is to hold on to them for as long as we can in order to collect those highly attractive coupons.

Which areas are you avoiding?

Generally, we avoid anything that we don’t understand. Our philosophy is to invest long-only, without leverage and without the use of derivatives. In a complex and uncertain world, where you have at the same time in different parts of the world both inflation and deflation, both growth and recession, both loose and tight monetary policy, it is important to follow a simple strategy. We have been doing this for more than 30 years.

More specifically, we tend to avoid the new contingent convertibles (CoCos), which banks have started issuing only a few years ago, as explained in the previous question. These are difficult to fully understand due to their complex structure and we don’t know yet how they will behave in a challenging market environment.

Which major risk are you currently identifying?

The US Federal Reserve holds bonds worth USD 4 trillion on its books as a result of its quantitative easing. It will be very interesting to see the market’s reaction once the Fed stops not only stops buying but actually reduces its holdings. This will indirectly lead to tighter monetary conditions as it will push Treasury yields higher. Bond investors would face significant capital losses as a result – unless they hold their very low-yielding bonds until maturity. We are well positioned for this via the instruments we own: for example, fix-to-float bonds pay coupons of 5-6% now, with a scheduled coupon adjustment in a few years’ time, taking into account the higher interest rates then. The same goes for floating rate notes, where the coupon is regularly adjusted.

How are your portfolios positioned?

We remain positioned for higher interest rates, as we have been for some time. This scenario would benefit our floating rate notes and fixed-to-float bonds, while our high-yielding fixed-rate bonds would prove fairly resilient. If rates remain at current levels, we will be equally content, since we can continue to lock in the around 6% annual yield of our holdings.

In terms of portfolio activity, we used the volatility over the summer period to take advantage of bond price declines that we felt were exaggerated. Hence we added to holdings at more attractive prices, while selling or reducing other holdings that had managed to hold up well but were consequently yielding comparatively less.

Nothing in this material constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. It is not an invitation to subscribe to any GAM product or service and subscriptions for shares or units will only be received and shares or units will only be issued on the basis of the current offering document for the relevant GAM product.  The statements and opinions in this material are those of the author at the time of publication and may not reflect his/her views thereafter. The companies listed were selected by the author to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the author. Certain laws and regulations impose liabilities which cannot be disclaimed. This disclaimer shall in no way constitute a waiver or limitation of any rights a person may have under such laws and/or regulations. In the United Kingdom, this material has been issued and approved by GAM London Ltd, 20 King Street, London, SW1Y 6QY, authorised and regulated by the Financial Conduct Authority.
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