The investment case for subordinated securities: Five managers’ views

Subordinated securities are often overlooked due to their nature; investors who favour investment grade debt may be familiar with the issuers – who are more often that not investment grade – but uncomfortable with moving down the capital structure, while high yield investors may not have the issuers on their radar. But with the potential to deliver attractive yields in a low rate environment where income is hard to come by, is now the time to be looking at preferred securities and corporate hybrids?

Fraser Lundie, co-head of credit, Hermes Investment Management

Hybrid securities, or ‘dequity’ as it is affectionately known on our desk, is a large market, offering significant yield pick-up in a yield starved market – so what’s the risk?

The three most important structural risks of hybrids are extension, coupon deferral and special event calls. If an investor can become comfortable with these risks, the return profile of hybrids can be attractive, but how can you decipher it? Essentially it can be divided into four components. The first two cover rates and ‘senior spread’, which represent the compensation for the credit risk at the senior level. Further down the structure, we also consider the ‘subordination premium’. This provides compensation for a lower recovery in case of default.  Finally, the ‘structure premium’ reflects the key risks of hybrids discussed above, and is by far the largest component of total return for a hybrid instrument.

So, the idiosyncratic risks require due care.  An example we like and hold is Solvay, a Belgian specialty chemical company. It has exposure to the growing specialty chemical segment as well as positive secular trends in the automotive, aerospace, smart devices and healthcare industries globally. Further, it emphasises stabilising leverage post aggregate acquisition history, while the structural risks of Solvay’s hybrids are mitigated by the importance of dividends for chemical companies, and our expectation that hybrids will remain a permanent part of the company’s capital structure.

Given the favourable credit trajectory of the credit, we think that as the company delivers on its plan over the next few years, the hybrid part of the capital structure will outperform senior – part of a broader theme we think is worth recognising at this juncture.

Dickie Hodges, manager of the Nomura Global Dynamic Bond fund

For us, convertible bonds allow us to gain exposure to specific sectors and companies where conventional bond issuance is limited or non-existent. The characteristics of some convertibles can also be very appealing, offering potential capital return upside if the equity price rallies, but with a meaningful ‘bond floor’. Such bonds offer an attractive skew of risk to the upside. Convertible bonds are primarily a capital generation opportunity, to our minds.

Subordinated credits are a very different story. As the recovery in both the global economy and particularly the financial system has continued, such bonds have performed strongly. In a world where attractive yielding securities are in short supply, these bonds have been well supported, and financial institutions continue to call these bonds as expected, in order to reassure investors and continue to have access to this source of funding.

However, their place in the capital structure means they are risky assets – this was clearly illustrated in early 2016, when fears grew that Deutsche Bank in particular might not meet the pre-conditions for it to pay the coupons on some of its deeply subordinated ‘co-co’ issues. Many subordinated issues sold off aggressively at that time.

Investing in such assets requires investors to be flexible in their approach. They must have the ability and experience to pair such bonds with hedging instruments – CDS, CDS options and even equity futures and options for example – to be able to manage downside risk through periods of volatility.

Julian Marks, portfolio manager, Neuberger Berman Corporate Hybrid Bond fund

First, consider the quality of the issuers. More than 90 per cent of those in the Bank of America Merrill Lynch Global Euro Investment Grade Hybrid Non-Financial Corporates Index are public companies rated by one – if not all – of the three leading agencies. Nearly all the issuers (and more than 70 per cent of their securities) are investment grade, which should come as no surprise given the preponderance of stable utilities and telecoms among their number.

How much spread are investors paid for this? The difference in yield between hybrids and the average investment grade bond is 200 basis points. To get the same spread in senior debt today, investors would have to go to high yield issuers rated BA2/BA3 or BB/BB. We believe that spreads more than compensate for the subordination; even after factoring in a premium for that risk, we estimate that there are more than another 100 basis points of spread available from hybrids relative to senior, on average.

Hybrids slip through a gap in traditional fixed income coverage. While investment grade portfolio managers will know the issuers, they may be uncomfortable with subordinated capital. High yield managers, on the other hand, are unlikely to have carried out credit research on these issuers. In addition, this may be a case of value being in the eye of the beholder. To investors, hybrids look like great value relative to investment grade senior and adjusted for subordination risk, whereas, to finance directors, hybrids look like great value relative to issuing equity – partly due to the tax advantages of debt over equity.

Bill Scapell, portfolio manager, Cohen and Steers Preferred Securities fund

Investment grade preferred securities typically offer some of the highest income rates in high grade fixed income markets, with yields that have recently been competitive with high-yield bonds. As of March 31, 2017, preferreds had higher yields than all the main core categories and all the selected non-core groups except high-yield bonds. This above average income component has contributed to attractive total returns over time while often providing a cushion in down markets.

Preferred securities have also had diversifying correlation with equities and other non-traditional asset classes. This is partly because banks and insurance companies, the largest issuers of preferred securities, are typically not well represented in other fixed income strategies, such as high yield bonds. Low correlations with other asset classes provide strong evidence for preferred securities as a portfolio diversifier.

In addition to offering traditional pure fixed-rate securities, the preferreds universe contains other structures, including fixed-to-float securities that dominate the OTC market (and are available on a more limited basis in the exchange-traded market). As their name implies, these instruments pay a fixed coupon rate for a specified period, after which the coupon may reset based on movements in an interest-rate benchmark. Such lower duration securities have proven to help cushion the impact of a rising interest rate environment (as coupons adjust upward), and active investors can choose from a wide variety of liquid structures to help manage rate risk.

Antonio Ruggeri, portfolio manager Oyster European Corporate Bonds, SYZ Asset Management

Valuations remain supportive of subordinated debt, even considering they are tighter than 12 months ago, as historical premiums and relative spreads remain above long-term averages.

Investment grade subordinated bonds (excluding CoCo’s) still offer 120 basis points above senior investment grade financials, for example more than twice seniors’ spreads (230 versus 110 basis points) compared to 1.5 times pre-crisis. Furthermore, they pay as much as high yield paper, but carry far better issuer credit profiles and ratings. This is where the main opportunity lies – subordinated bonds are perceived riskier than they really are and investors who understand them can be handsomely rewarded.

Meanwhile, selectivity is key for CoCos, this year’s best performer, which after the enthusiastic ‘start’ in 2013-2014, suffered from low transparency, especially on regulators’ attitude towards coupons payment for lower capitalized banks. Finally, after last summer, the ECB and other central banks changed the way they define capital needs, distinguishing between requirements and guidelines and lowering the former that was prescriptive to the level of non-viability for banks below which a coupon cancellation may be imposed.

The combination of regulation changes and a risk-on environment has triggered a powerful start of 2017 for CoCos, further pushed out by the pro-EU political outcomes. This, in turn, will probably also revitalize the primary market. In fact, as of December 2016 only 18 per cent of banks had already reached the minimum 1.5 per cent of AT1 capital required, whereas 75 per cent of them were still below 1 per cent.

The total CoCos market from western European banks has reached around 40bn, but the 1.5 per cent requirement, at least for major institutions, leaves another 30bn of space for new issues. We expect the current benign environment will accelerate issuances through year-end, offering more attractive opportunities for newcomers into the asset class.