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Subordinated Debt – The opportunity hidden in negative yielding debt

19 November 2019

The eurozone remains in a low growth, low inflation environment. Romain Miginiac, Head of Research at Atlanticomnium, believes the record levels of negatively yielding debt worldwide could be to the advantage of European financials offering subordinated debt.

During 2018 and 2019, mounting geopolitical tensions have led to rising macro uncertainty – whether it be trade wars, Brexit or other topics. In turn, macro data prints have turned softer, with global industrial purchasing managers’ index (PMI) readings weaker and consensus growth estimates downgraded, likely driven by lower global trade flows due to trade wars and the delaying of corporate investments reflecting this uncertainty.

Nevertheless, weakness in the industrial sector is counterbalanced by a highly resilient services sector due to strong domestic demand from consumers and healthy labour markets. Moreover, central banks’ willingness to support the economy through interest rate cuts and asset purchase packages provides another pillar of support to the global economy.

In the eurozone, we remain in a low growth, low inflation environment. With the European Central Bank (ECB) cutting rates to a record -0.5% low and reigniting its quantitative easing programme, the outlook for interest rates looks relatively straightforward – lower for longer. As the current state of the economy stands, and with any significant rise in rates unlikely at this point, we expect euro fixed income to remain well supported. While years of highly accommodative monetary policy has supported a strong bull market in bonds, culminating in a record USD 15 trillion of negatively yielding debt worldwide1, income yields have now fallen to record lows. With an average yield of circa 0% in euro fixed income2 , the key challenge for investors is how to generate performance in the current negative rates environment.

Chart 1: Yields on EUR-denominated fixed income have plunged as rates have fallen

Source: Bloomberg, Bloomberg Barclays Indices. Data as of 03/10/2019

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

Compressed risk premia offer limited relief for traditional high income investors

Ultimately, future bond performance is a function of income yield and capital gains or losses from price performance and defaults. Therefore, investors should be rewarded for both interest rate risk (price volatility due to changes in interest rate) and credit risk (price volatility due to changes in credit spreads and default risk).

The current negative rates environment, where 5-year bunds are offering a -0.8% yield for example, has led to yield compression in most parts of the fixed income market and severely impaired the risk-return trade-off for bondholders in most bond segments.

Investors can increase their duration (interest rate risk) by purchasing longer-dated government or corporate bond holdings in order to enhance income yields. In exchange, volatility increases as bond prices become more sensitive to changes in interest rates. This strategy has paid off since the eurozone crisis with a significant outperformance of 10-year+ bonds compared to shorter-dated bonds. Nevertheless, with an average yield of circa 1% on 10-year+ corporate bonds in EUR, investors are vulnerable to a back-up in rates, and income yields offer close to no protection to mitigate impacts on total returns. As an illustration, it takes only a marginal rise in rates of less than 10 bps (ie 0.1%) to offset a years’ worth of income yield for investors in long-dated EUR corporate bonds.

Chart 2: Declining income yields leave investors vulnerable to interest rate risk

Source: Bloomberg, Bloomberg Barclays Indices. Data as of 04/10/2019.

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

Another strategy that has outperformed since the eurozone crisis has been the hunt for yield in sub-investment grade (IG) bonds – high yield (HY). Very low default rates, underpinned by healthy fundamentals, as record low borrowing costs support the ability to service debt, has led to strong total returns in euro HY. But going forward will investors be properly rewarded for taking significant credit risk? Headline credit spread levels remain arguably attractive at circa 390 bps for euro HY in a record low rates context. However, when put in the context of average default rates for HY – we believe these are less appealing. Moreover, leverage has been rising and the recent weakness in industrial data and deceleration in growth raises questions on the future path of default rates, in our view.

Chart 3: Despite higher yields – high yield investors exposed to significant idiosyncratic risk over the long term

Source: Bloomberg, Bloomberg Barclays Indices, S&P Global Ratings. Data as of 04/10/2019.

Subordinated debt – an attractive hiding place for high income investors

For high income investors unwilling to compromise on interest rate risk or credit risk, we think subordinated debt is an attractive alternative.

What is subordinated debt and why does it exist? Put simply, subordinated debt covers all debt ranking below senior debt. For corporate issuers this is typically issued for ratings agency purposes, given the favourable treatment on leverage metrics (a percentage of the subordinated debt will count as equity). For financials, this is driven by regulation, whereby regulators allow issuers to fill a portion of their capital or solvency requirements with subordinated debt. For issuers the advantage of issuing subordinated debt is the significantly lower cost compared to equity. As an example, the average cost of equity in the European banking sector is around 10%, however the average yield on banks’ junior subordinated perpetual debt (AT1 contingent convertible bonds (CoCos)) is currently circa 4%. Therefore, issuers have an incentive to issue junior debt, especially in the financials sector where supply is driven to a large extent by regulation.

Within the capital structure subordinated debt ranks below senior debt but ahead of equity in insolvency. As subordinated debt is lower down the capital structure compared to senior unsecured debt, recovery in case of bankruptcy is expected to be lower – a source of risk for bondholders. Rating agencies typically rate hybrid debt several notches lower than the issuers’ senior debt to reflect these lower recovery rates. Nevertheless, as the probability of default is the same for both senior and junior debt, going down the capital structure of quality issuers is an interesting value proposition, in our view, as one can capture higher yields with very low default rates. Beyond being compensated for the extra risk in case of insolvency, investors are also rewarded due to the structure of the instrument. Subordinated debt instruments are often longer dated (30-year+, perpetual) which carries some additional risk. This is mitigated by (1) call features and effective maturities which are often shorter than the final maturity and (2) fixed-to-floating coupon structures, where the coupon is reset (typically to a fixed spread plus the benchmark rate – for example Libor or the 5-year government bond yield) if not called, providing protection in case of rising interest rates. Therefore, we see credit risk mitigated by a very low probability of default for high quality IG issuers and interest rate risk mitigated by bond call features and coupon structure.

The financials sector is particularly attractive, in our view, given its continuously improving fundamentals. Since the financial crisis, stricter regulation has led to a strong recovery in the sector, with capital ratios more than doubling and a significant de-risking of balance sheets. Banks and insurers have built significant capital buffers to protect bondholders in case of an economic downturn, with the sector now highly resilient. As regulation continues to evolve, with Basel IV, a key piece of banking regulation that will lead to further capital accumulation, we believe the investment rationale for financials is intact.

The only caveat to investing in subordinated debt is the in-depth analysis required to navigate through the asset class; a strong understanding of issuers through in-depth bottom-up analysis is required to mitigate credit risk. Second, as instrument features vary widely, especially in the financials sector where issuance follows strict regulatory guidelines that are continuously evolving, a deep understanding of the terms and conditions of specific bonds by rigorously analysing the prospectus is required. This ‘friction’ creates significant opportunities for investors with the expertise and resources to carry out detailed analysis of issuers and instruments.

Valuations remain highly attractive on subordinated debt

The performance of subordinated debt has been strong – returning close to 7% per annum in the past five years (using AT1 CoCos as a proxy)3 . The low rates environment and spread compression have contributed to strong total returns, however income yield has been a significant part of total returns – an attractive feature in a world of ultra-low rates. Going forward, we believe valuations remain attractive – especially compared to high yield debt. For equal average ratings, AT1 CoCos provide almost 2% additional annual income compared to BB high yield, while corporate hybrids and subordinated insurance provide similar income to BB high yield with higher average ratings. We continue to see significant opportunities in financials subordinated debt, a sector where regulation has led to significant improvements in fundamentals. Beyond these improvements, subordinated financials debt exhibits very limited sensitivity to interest rates given attractive instrument structures (fixed-to-floating coupon structures and call features). Finally, the stable macro backdrop remains supportive for credit, and we believe the ongoing hunt for yield should continue to drive demand for higher-yielding asset classes. Overall, with subordinated financials offering yields close to 4% for euro-denominated bonds, we think the asset class remains an attractive hiding place for high income investors unwilling to compromise on credit or interest rate risk.

Chart 4: Subordinated financials exhibit very limited sensitivity to interest rates

Source: Bloomberg, Bloomberg Barclays Indices. Data as of 04/10/2019.

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

Chart 5: Subordinated debt screens extremely cheap on a ratings-adjusted basis compared to high yield

Source: Bloomberg, Bloomberg Barclays Indices. Data as of 30/09/2019.
1Source : Bloomberg Barclays Global Aggregate Negative Yielding Debt Index as of 04/10/2019.
2Source: Bloomberg Barclays Euro Aggregate Index as of 04/10/2019.
3Bloomberg Barclays Contingent Capital EUR Total Return Index from 03/10/2014 to 04/10/2019.

Important legal information

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. Reference to a security is not a recommendation to buy or sell that security.