In September 2008, funding and liquidity problems in the banking sector, which had been troubling the market since August 2007, took a dramatic turn for the worst as Lehman Brothers filed for bankruptcy. The associated collapse in confidence was felt on a global scale, with the fallout hitting financial markets, trade, employment, housing and credit availability. In turn, a massive global fiscal and monetary response was…
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needed to help resolve the resulting ‘credit crunch’ and control one of the worst recessions in modern memory.
One of the notable by-products of this credit crunch has been the increased focus of both the regulators and the wider public on financial services and the activities of the individual institutions. Basel III, the much-discussed new regulatory framework for banks, could help reduce the systemic risk that financial institutions pose to the marketplace and to society in general. The framework is still subject to ratification by member countries, but may be implemented in the not too distant future.
As a result of Basel III and the upgraded regulatory framework, banking sector fundamentals could improve substantially over the coming years. Balance sheets within the sector are already recovering, having come under severe stress during the credit crunch, and yet financial sector valuations within the corporate bond market have not returned to the levels witnessed before the crunch. As such, we believe the fundamentals of the financial sector, combined with attractive valuation prospects, create an attractive package for corporate bond investors. In particular, we see good value in European financial sector bonds, especially when compared to their non-financial investment grade counterparts.
Financial sector bonds currently offer better value than non-financials, with improving credit metrics, attractive valuations and market technicals underpinning the opportunity for credit investors.”
Give me banks
We believe the financial sector corporate bond universe offers a good opportunity set in terms of taking absolute and relative value positions to build a good quality portfolio that can generate both income and capital growth over the long term. Differentiation between issuers can prove to be a good source of returns within the sector, but so too can choosing between the various tiers of the bank capital structure (see figure 1 below). Indeed, for those who are able to properly analyse the sector, robust opportunities can appear.
It is worth noting, though, that it is not only the subordinated part of the market that offers attractively valued credit opportunities at the moment. Even senior bank bonds, which make up a large part of the funding for banks, offer higher yields than senior non-financial bonds. If this trend were to persist in the long run (i.e. non-financials could continue raising money from the markets at better terms than the banks), it could mean that non-financials need not borrow from banks at all. In our view, this is not a sustainable trend. Banks – being the intermediaries of capital – should be able to borrow at cheaper levels than non-financial borrowers, resulting in lower spreads over time.
Basel III – addressing systemic risk
Along with the valuation anomaly outlined above, Basel III seems to be creating some interesting opportunities for bond investors, not least because insurance regulators have also been watching developments closely and are expected to apply some of these principles in their Solvency II review.
The financial sector – normally considered to be defensive and high quality – needed widespread taxpayer-funded bailouts to rescue the banks during the credit crunch (in several cases, placing substantial burdens on sovereign finances). In the aftermath, there has been significant political pressure on regulators to ensure that such a financial crisis can never happen again.
A key outcome was a set of revisions outlined by the Basel Committee in December 2009 revisions focused on improving the quantity and quality of capital held by banks, and which have since come to be known as Basel III. If these revisions are implemented, as we expect them to be, the result will be safer, more creditworthy banks. Even though there is a generous timetable for implementation, we expect many regulators to require banks under their jurisdiction to move to Basel III as soon as possible. Indeed, since 2008, a number of banks have recapitalised to the extent that they are already compliant with the new rules. So far, so good for bondholders, it would seem – more equity in the banks means a greater cushion against default.
The Basel III proposals also include a reassessment of what kind of instruments can contribute to regulatory capital. At the moment, financial institutions issue various types of hybrid bonds (in addition to equity) that regulators consider as capital. Tier 1 capital bonds are the most subordinated debt securities a bank can issue, ranking just ahead of equity. Tier 2 capital bonds rank ahead of Tier 1 bonds, but behind senior bonds.
This current format will have to be changed and the entire capital stack between equity and senior secured debt redefined. This has important implications for existing bank debt instruments, and for the types of instruments that will be available to debt investors going forward.
The future of bank capital
Hybrid debt instruments (occupying the space between debt and equity) have been structured with call features and, in some cases, have been perpetual with no fixed maturity date. Issuers and bondholders have relied to some extent on a ‘gentleman’s agreement’ to call the bond at the first call date, thus making the call date the de facto maturity date. Most banks have kept that promise throughout the crisis, even in cases where calling the bonds was not economically attractive.
However, regulators dislike the features that make the hybrid instruments ‘bond-like’. As these bonds qualify as capital, they would rather they were ‘equity-like’. As such, the proposed new eligibility rules require there to be no incentives to call. The instruments must also have principal write-down features and coupons that are easy to switch off without penalty. Regulators and some issuers remain hopeful that those structuring capital will be able to perform the alchemy of converting equity into debt within the confines of the new regulations. To us, however, this is a circle that cannot be squared.
Furthermore, regulators appear to have become enamoured with the concept of contingent capital instruments – debt instruments that convert to equity while the bank remains a going concern. In the event of conversion, bondholders are made ‘pari passu’ (having equal rights of payment or level of seniority), or even subordinate to equity holders. This consequently subverts the capital structure in which shareholders provide a cushion for bondholders in return for unlimited upside.
We see such instruments as quasi-equity not debt from an investment perspective. As such, we would only look to participate where the coupon was high enough to offer equity-like returns. On a positive note, however, existing hybrid structures will no longer qualify as capital after the grandfathering period. Issuers are incentivised to call these bonds at the first opportunity and replace them with new structures that comply with the new regulations. Contrary to their expectations, regulators have consequently made the existing hybrid structures even more debt-like.
The ‘bail-in’ framework
We accept that it is not right that one of the consequences of taxpayers propping up failing banks should be that bondholders get bailed out. One of the regulatory failures highlighted between 2008 and 2009 was that, for many banks, declaration of bankruptcy would have had systemic consequences that meant taxpayer support was more expedient. Regulators lacked an effective resolution framework that would enable them to take over non-viable banks, recapitalise them or impose an orderly wind down.
A full bank resolution framework for non-viable banks would remove the distortion caused by unintended taxpayer bailouts of bondholders. It would also allow the bond market to give clear signals about the perceived credit quality of individual institutions. As an interim measure, we are comfortable with the Basel Committee’s proposals to require subordinated debt to have clauses ensuring loss absorption in the case of non-viability. The trigger for conversion remains bank failure, though we would need to ensure that shareholders would bear the first loss, prior to bondholders.
It is not clear whether the terms of existing bonds (especially senior unsecured bonds) would be changed to allow them to participate in a ‘bail-in’. This, in principle, should not be a problem for bondholders as long as the trigger for bail-in was set at a reasonable level. It would create a two-tier market for senior secured bonds: the ones that the market perceives to be too big to fail, and then the rest. An example would be Santander and the Cajas in Spain. The price impact of the bail-in clause being introduced retrospectively would be less in the case of Santander.
Old opportunities become new opportunities
Investors have yet to decide how to categorise the new style bonds that will be issued. With that in mind, we will be looking at the documentation carefully to make sure that bondholders’ rights have not been overlooked in the zeal to create new-style capital instruments. However, as a result of Basel III and the related changes (should they proceed as currently outlined), we are also expecting reduced opportunities to invest in debt lower down the capital structure.
Banks will have more equity and will be less leveraged, which will improve overall credit quality, but bondholders won’t be able to rely on taxpayer bailouts if the bank gets into trouble.
As the economy continues to grow at a moderate pace, and banks continue to strengthen their balance sheets, the oldstyle bank capital bonds begin to look very attractive. Clearly, existing instruments with more bond-like features will become scarcer over time as they mature or are called (for which there is now a greater incentive). We believe outstanding lower tier 2 bullet debt (fixed rate, non-callable debt) looks particularly attractive, as do upper tier 2 instruments, which will no longer be issued at all. Outstanding Tier 1 structures also look very interesting because we believe regulatory developments increase the probability of call at first call date.
An attractive mix for future returns
All in all, we believe this backdrop is creating some strong opportunities in financial sector bonds. The sector currently offers better value than non-financials, with improving credit metrics, attractive valuations and market technicals underpinning the opportunity for credit investors. Thus, should the proposed Basel III regulatory framework now be implemented, as we believe it will be, the reduction in systemic risk and the creation of better capitalised, more creditworthy banks should bring about an even better risk-adjusted proposition versus non-financial credits.
The views and opinions contained herein are those of Roger Doig, credit analyst, and Sarang Kulkarni, fixed income fund manager, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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Source: BONDWorld – Schroders
Roger Doig, credit analyst
Sarang Kulkarni, fixed income fund manager