In a world of record low interest rates, traditional bond investors face an asymmetrical risk-reward scenario, capturing little income while facing the threat of declining prices due to rising rates. Atlanticomnium’s Head of Research Romain Miginiac believes subordinated debt can offer an attractive value proposition, potentially enabling investors to capture high income with low sensitivity to interest rates.
The low rates conundrum
With global interest rates near all-time lows and a ‘lower-for-longer’ rates environment, fixed income investors are facing a challenging conundrum. On first glance, and with a 0.3% average yield for the EUR investment grade (IG) corporate bond market (Bloomberg Barclays Euro-Aggregate Corporate Index as of 30 March 2021), there are few hiding places in fixed income markets. With little income on bonds and a high vulnerability to rising interest rates, the pay-off has become asymmetric, with returns skewed to the downside. The downside can be painful. One extreme example is the Austrian government’s century bonds – 0.85% bonds issued last year which mature in 100 years (2120) – which have seen their price drop from 140 to 100 in 2021, with only a modest interest rate increase of 0.4%. The price drop is equivalent to more than 40 years of income.
Fortunately, there are areas of the bond market offering more attractive yields with lower sensitivity to interest rates. We see subordinated debt as offering an attractive value proposition for investors looking for high income and cautious on interest rates.
High income can provide a head start for subordinated debt investors
First, subordinated debt is characterised by high income driven by the wide spreads offered by the asset class. Taking EUR additional tier one (AT1) contingent convertibles (CoCos) as an example, average yields are currently 3.4% with investors capturing circa 400 bps of spread, a +300 bps pick-up compared to EUR IG corporate bonds. When forecasting total return performance, the income component is static and not impacted by rates, unlike prices that fluctuate.
For investors, more income is equivalent to a large ability to absorb price declines, while keeping total returns positive. For example, on EUR AT1s, a 3.4% aggregate price drop would lead to zero total return (using the yield of 3.4% as a proxy for income) while EUR IG investors would only be able to absorb a 0.3% decline in prices. In the context of rising rates, this is a key differentiator, as low rates exacerbate the risk of rising rates with yields around all-time lows. We believe higher yielding fixed income asset classes, such as subordinated debt, offer greater protection against rising rates.
The duration fallacy in credit investing
Second, there is the question of how different segments of the bond market actually behave in periods of rising rates. In theory, as rates rise, bond prices should move down in-line with the average duration. For example, the Bloomberg Barclays Euro-Aggregate Corporates Index has a duration of 5.3 compared to 4.6 for the Bloomberg Barclays Contingent Capital EUR Index, implying a 5.3% and 4.6% respective drop in the market price for a 1% rise in yield. With a lower duration, subordinated debt has a slightly lower theoretical sensitivity to rates.
However, actual sensitivity can differ significantly from bond duration metrics. This is because duration measures a bond’s sensitivity to a 1% change in yield. For risk-free government bonds, this is an accurate measure, as the yield is purely a reflection of interest rates. However, this does not necessarily hold for corporate bonds.
As an example, assume issuer XYZ issues a corporate bond with a five-year maturity and a 5% coupon (issued at par with a 5% yield). Assuming the five-year government bond yield is 2%, the credit spread of the bond is 300 bps or 3% (what investors are paid for the risk of default). For simplicity, let us assume the duration is five. This models a 1% change in yield, the sum of the risk-free rate and the credit spread. In the event of rising interest rates, the sensitivity of the bond would be five (ie a 5% drop in price for a 1% rise in yield) if credit spreads remain unchanged. However, if credit spreads tighten the impact would be lower, and vice versa if spreads increase. Therefore, sensitivity to interest rates is lower than duration if spreads tighten.
This is especially important, as typically credit spreads and interest rates tend to be inversely correlated (credit spreads tighten when interest rates increase). The simple explanation is that when interest rates rise (especially rising long-term rates and a steeper curve) this reflects an improving macro environment (rising GDP growth, inflation expectations) which is supportive for risk assets, such as equities and credit. Therefore, the rates impact is typically (partially) offset by the rates effect.
This effect is exacerbated by the level of spreads. The higher the level of credit spread of the bond, the higher the ability to absorb the rise in yields and the higher the spread tightening given an improvement in macro conditions. The EUR IG corporate market, with average spreads of around 90 bps, can in theory only absorb a maximum 90 bps of increase in rates, while AT1s CoCos have more scope to compress with a circa 400 bps spread.
A useful example to illustrate this is the performance of several segments of the US dollar bond market since August 2020, as the 10-year US Treasury yield has surged from 0.5% to 1.7% currently. In Chart 1, we have broken down the performance of several areas of the fixed income market, focusing on income, price change from rates and price change from spreads. Treasuries have been significantly impacted by rising rates, a 7% decline in price was only offset by a 1.1% rise in income. For corporate bonds the large impact from the change in rates was offset by income and tighter spreads (decline of 38 bps), leading to a higher total return. For AT1 CoCos, the relatively low duration risk led to a 2.6% drag from higher rates, and strong spread compression (decline of 126 bps) and high income led to an overall 8% positive total return, and outperformance of 13.9% and 11.8% compared to government bonds and corporates respectively.
For the financial sector, the positive impact of higher rates on fundamentals should also be considered. In general, higher rates are positive for rewards, as this generally leads to a higher net interest margin and therefore a tailwind for bank benefits and credit profiles. If accompanied by an economic expansion, this also supports higher demand for credit, higher fee income and lower credit losses.
Chart 1: Performance of USD fixed income during a period of rising rates (4 August 2020 to 30 March 2021)
To our minds, what stands out from this example is that higher spreads offer the ability to offset the impact of rising rates through high income and tightening spreads. In high income asset classes, such as subordinated debt, with typically lower duration, and higher income, total returns are less impacted by rates moves.
Extension risk provides another leg of potential upside
Finally, extension risk is another tailwind for subordinated bondholders in a rising rates environment. We have written in the past about extension risk which is essentially the risk of prices of perpetual bonds declining due to either bonds not being called or fears of bonds not being called at the next call date. The decline in price compensates bondholders for a potentially longer holding period.
In a rising rates environment driven by positive macro trends where the fundamentals of financials improve and spreads tighten, extension risk is expected to be a tailwind. As spreads tighten, it becomes cheaper for banks to refinance their perpetual subordinated bonds compared to not calling, which in turn should lead to a re-pricing to call of the market. As the market re-prices to call, there is potential price upside for bondholders which could lead to further outperformance compared to other high-income asset classes.
Taken altogether, we believe subordinated offers a solution for bondholders in a challenging environment, with an attractive income yield and lower sensitivity to rates compared to IG corporate bonds. We continue to see supportive tailwinds and attractive valuations to support the asset class.
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 of current or future trends. 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. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.