A specialist in the fixed income field takes a tour around some of the sometimes less explored parts of the fixed income environment to examine the benefits - and risks.

Satish Pulle, who is head of financials and asset-backed securities at ECM Asset Management, has recently written a white paper on the subject of relatively high-yield subordinated credit as issued by financial institutions, such as contingent convertible bonds (these are bonds that convert to equity contingent on a certain trigger event by the issuer, hence their name). This publication wanted to drill into the substance of this market to find out more because of how investors, we are told, are looking into new areas in the hunt for yield in a low-rate environment. (ECM Asset Management is part of Wells Fargo, the US bank, and was founded in 1999.)

What is attractive about the risk/return characteristics of subordinated financials credit? Please provide examples and some data.
ECM expects returns in 2015 of 6-7 per cent for CoCo (contingent convertible) bonds, 4-5 per cent for high-yield financials, and 2-2.5 per cent for investment grade subordinated financials…these are attractive fixed-income returns.

Subordinated financials credit offers somewhat higher yields than other sectors…as well as improving credit quality…leading to attractive relative risk-adjusted returns. As many issuers are strengthening their credit quality, attractive yields appear to be sustainable.

The combination of improving credit fundamentals, significant issuance, and attractive yields is unique in credit markets today. Higher capital levels, such as the recent €7.5 billion equity issuance by Banco Santander, provide substantial additional support to credit investors in subordinated debt.

Why should investors specifically create a new bucket for high-yield financials in their asset allocation mix? In what way is this different from any other high-yield assets?
High-yield financials are clearly in a growth mode. By way of example, high-yield financials in the Merrill Lynch Euro Financial High Yield Constrained Index (HEBC) grew from €6 billion/$9 billion in 2008 to €80 billion/$97 billion in 2015. Further, when you fold in CoCo bonds, which are currently valued at €103 billion/$117 billion the total outstanding high-yield financials come in around €184 billion/$214 billion, which clearly warrants stand-alone status.

ECM believes the aggregated issuance could amount to a stand-alone sector for high-yield financials consisting of €300 billion/$340 billion in issuance by 2020. High-yield financials have a low correlation to high-yield corporates, thereby strengthening the case as a stand-alone diversifier.

There are a number of other differentiators that strengthen the case for a specific high-yield financials bucket, these include:

-- Financial issuers tend to be better-rated organizations than the average corporate high-yield issuer;
-- A larger and growing proportion of bank issuers are listed companies, able to raise equity to recapitalize themselves when needed;
-- Bank regulation, which is becoming more intensive and intrusive, favour high-yield financials in that they are mandating Additional Tier 1 (AT1) bonds...which are normally rated high yield; and

-- While banks typically suffer somewhat higher loan losses during recessions, they are normally in a financial position whereby they can protect subordinated debt investors during these periods.

Please talk about what is driving such subordinated debt. Is it mainly structural, or regulatory…or other?
Post-2008 financial regulations have been a substantive driver of high-yield financials issuance. New regulatory requirements, including Basel III and central bank stress tests, force banks to increase capital levels and to issue significant amounts of subordinated debt.

For example, European regulators now require banks to issue AT1 bonds amounting to 1.5 per cent of risk-weighted assets by 2019. In addition, several national regulators are requiring banks to maintain leverage ratios at or above 3-4 per cent of total assets, which is likely to lead to increased AT1 bond issuance.

Structurally, the unique characteristics and performance traits of high-yield financials are clearly resonating with investors seeking uncorrelated returns to high-yield corporates.

Can you talk a bit about the issue of political uncertainty and the regulatory angle that is behind such issuance?
Rising litigation costs for some banks, such as RBS, could cause some volatility, but is unlikely to lead to a significant impact on subordinated debt.

The prevailing Greek situation is, at some point, likely to be resolved with agreement between the new government and the Troika; the ECB recently eased collateral requirements for Greek banks, pointing towards continued support. In the unlikely scenario of a Greek Euro exit, the temporary significant disruption to markets could present an opportunity to reduce short positions and increase longs, especially given the ECB’s supportive stance.

During the course of this year, we could see increasing political uncertainty, especially within peripheral economies. We could also witness reform fatigue which could prompt leadership changes and perhaps changes to the banking system rules and regulations.

What are the opportunities in bank senior and subordinated debt from emerging market countries and periphery recovering countries?
In terms of issuance, we have seen an increase in Lower Tier 2 issuance, especially by French banks and insurers. In addition, high-yield financials issuance is increasing from emerging markets banks in Europe and Asia (Russia, Turkey, and India) as they grow their balance sheet assets.

How would you say investors should get exposure to this asset class? Through a fund? Some other channel?
Subordinated financial credit is a complex and rapidly changing area of the fixed-income arena. A strong credit research team is necessary to invest in this sector, as credit analysis of issuers and bonds is critical to identifying likely out-performers and under-performers.

What are the risks? Are there any serious drawbacks, points that investors should be aware of?
Every asset has risk, so it’s always a matter of reconciling risk and return. There are some issues particular to subordinated financials, such as the fact that issuer diversity is less than that of the corporate high-yield sector. These need to be considered carefully.

Investors should also be aware that subordinated debt is lower in the capital structure than senior debt, and coco bonds are typically the most junior debt instruments issued by a bank.

How has the experience of the financial crisis shaped how we should think about such high-yield debt? Is there a danger of repeating past mistakes?
Compared to pre-crisis levels, most issuers have much higher capital ratios and lower leverage. At the same time, there’s been a reduction in high-risk assets such as collateralized debt obligations. Banks have become more risk-averse in their lending and trading portfolios.

Regulatory oversight is more vigilant, as evidenced by the European Central Bank’s quantitative easing programme, ongoing US rulings on financial stability, and, as we have seen in Portugal, some examples of judicious bailouts to limit systemic risk.
 
Now that bond markets have pushed government bond yields to low levels, some countries such as Austria are experimenting with bail-in of senior bonds of bad banks such as HETA (previously Hypo Alpe Adria). This development needs to be watched carefully, particularly if it spreads to other countries such as Germany.