Tier 1: A question of generation

From the death of legacy instruments to the hot spot of AT1, the subordinated debt asset class offers attractive opportunities even after the recent rally, according to Julien de Saussure, fund manager at Edmond de Rothschild Asset Management (France). Here, he explains his strategy towards the varied instruments and highlights the key opportunities and risks to be considered.

Subordinated bonds of banks and insurance companies have strongly performed since the beginning of 2012 and are likely to continue to do so in this low yield, low inflation environment.

From a fundamental standpoint, banks and insurance companies have put a strong emphasis on strengthening their solvency positions. Banks is also one of the few sectors where issuers will continue focusing on deleveraging, which is positive from a creditor standpoint.

We also believe banks will benefit from the recently announced unconventional measures by the European Central Bank.

The real area of concern for European banks experiencing subdued profitability at the same time as elevated NPLs is largely going to find an answer in the asset quality review (AQR) and stress tests run by the ECB and European Banking Authority this year. Not only will the transparency and consistency of data be greatly improved, but the amounts of capital raised and increased provisions, either before or after the comprehensive assessment, will dramatically strengthen the overall solvency of the sector.

There remains the question whether a bank needs to fail in the process for the sake of credibility. Let’s just say we hope to have been selective and thorough enough to avoid trouble in that eventuality. In any case, we do not expect any failure to be disruptive.

Finally, in the medium term, the EU Banking Union is also a very positive development for the sector and its creditors.

Our subordinated debt investment strategy

At Edmond de Rothschild Asset Management (France) we manage approximately Eu1bn of financial debt in various portfolios, with a strong focus on subordinated instruments, which make up more than 50% of these.

These funds include long-only open funds where subordinated bonds are used both to express specific convictions or to increase the beta versus benchmarks. We also manage Solvency Capital Ratio (SCR)-optimised mandates dedicated to institutional clients with a focus on Tier 2 non-CoCo bullet vanilla subordinated debt. Lastly, we manage Edmond de Rothschild Signatures Financial Bonds, our flagship funds of approximately Eu500m dedicated to financial subordinated bonds. The investment universe is the entire capital structure (except equity) of banks and insurance companies, with a strong emphasis on legacy structures issued under the guidelines of Basel II and Solvency I and that are unlikely to survive as we move to Basel III and Solvency II. The anticipated “death” of this segment of the asset class is a very powerful performance driver as it creates a technical scarcity premium, with no supply under the old guidelines (hence limited repricing risk due to primary activity), while demand remains strong for a segment with decent spread and limited interest rate sensitivity in a low yield environment. The exact way these bonds will disappear (early call vs. late call vs. tender offer) also creates compelling investment cases. In the end, even after the recent rally, we still see legacy Tier 1 bonds as the sweet spot in the capital structure with the best risk return profile. We like insurance bonds with a mix of good valuations, better fundamentals than banks, and Solvency II’s starting point likely two years after that of Basel III/CRD IV helping smooth the natural attrition of the legacy segment.

Our investment universe is almost exclusively in Europe, where we see both value and sufficient diversification. Europe is also unique in undergoing regulatory changes in both the banking and the insurance sectors. And of course we pay a lot of attention and allocate gradually more and more (currently 25%) of our funds to next-generation structures, mainly 30NC10 Tier 2 for insurance and CoCos with either Tier 2 or Tier 1 hosts for banks.

Primary markets

Primary markets have been extremely active since the beginning of the year. Whereas deleveraging has been a key focus for banks in the last five years and investors in bank bonds have benefited from net negative issuance, 2014 is likely to be the year when new supply outweighs natural redemption in the subordinated segment. While most deals have performed strongly, we remain convinced of the absolute need to be selective and to review thoroughly prospectuses while new issuers and new structures come to this very technical market.

New structures

Investors are now familiar with the well-identified structures. As far as we are concerned, we differentiate six different types of structures:

• For insurance: Solvency I dated bonds; Solvency I undated bonds; and Solvency II Tier 2 bonds
• For banks: Vanilla Tier 2 bonds; CoCos with Tier 2 hosts; and CoCos with Tier 1 hosts.

Insurance

We generally like recently issued insurance bonds with Solvency I features (e.g. Groupama, Delta Lloyd or UnipolSai undated bonds) where the prospectuses’ language is generally more bondholder-friendly. And it allows us to continue to invest in “legacy” instruments even in the primary market, which could seem counter-intuitive. There is a short window of opportunity before a likely cut-off date at the end of this year when issuers can issue bonds that are likely to benefit from a full grandfathering. As investors, we like the fact that the extension risk on these bond is very limited as they will not comply with solvency rules after they lose their grandfathering treatment. But we should also be aware that this is something of a regulatory arbitrage by issuers and any change in the current grandfathering assumptions may jeopardise these investments — hence the need to review carefully variation clauses or regulatory par call clauses in the various documentation.

A lot of Solvency I dated bonds (Macif, Coface, Poste Vita, Generali, Intesa Vita) came in bullet format, which can be compelling for our institutional dedicated mandates where a callable feature triggers different accounting treatment for French insurance companies.

We are yet to see the new Tier I term-sheet under Solvency II guidelines. And the biggest part of the primary market in insurance comes in the 30NC10 format with regulatory lock-in and mandatory coupon deferral in case of SCR breach — there are obviously some differences between countries and rating agencies. We like these structures, which offer higher credit spread duration and exposure on new issuers.

The only element of doubt in these structures is the recent debate opened after the release of the latest EIOPA guidelines, which would tend to prohibit fixed/floating coupon structures. This is obviously a source of concern that we are carefully monitoring given that: (i) most 30NC10s in the market have such fixed/floating structures; (ii) most 30NC10s have regulatory par call options should they lose their regulatory treatment (with very varied legal wording in the docs, however); and (iii) most 30NC10s trade way above par. Most issuers have actually issued these structures with a view to calling them after year 10. As a result, as long as these bonds at least qualify under grandfathering provisions, we consider it should not be a major source of worry. That might, however, justify reducing exposures to very asymmetrical high cash prices.

CNP recently issued a 31NC11 Tier 2 avoiding the fixed/floating structure, which emphasises that issuers are very well aware that the EIOPA guidelines will matter.

On insurance, another market theme we have looked at is insurance subsidiaries of bancassurance groups that are replacing internal subordinated loans by external subordinated bonds, either pre-IPO (e.g. Coface, NN Group) or as substitute/risk mitigation versus the Danish compromise (e.g. Intesa Vita). They generally offer value and diversification benefits.

Banks

Vanilla Tier 2 with no CoCo features are interesting bonds for relative value trades and for risk diversification. Again, the structure is very well understood (though the interaction with the Bank Recovery & Resolution Directive and in particular the minimum requirements for own funds and eligible liabilities (MREL) might change). We have taken the opportunity to return to good names from peripheral countries that had been absent from the subordinated primary markets since the crisis. This is a way of benefitting from the periphery-core compression trade on simple structures with decent spread pick-up. The recent Bankia Tier 2 is a good illustration of this.

We have also taken advantage of vanilla Tier 2 issuance in jurisdictions that had been less prominent in this field. The recent LBBW callable Tier 2 is a good example. Firstly, the German banking industry is very heterogeneous in terms of issuers’ strengths and issuer type. Secondly, lots of the legacy subordinated bonds issued by German banks (notably Landesbanks) had come in the form of Stille Beteiligungen or Genussscheine, which are not only very specific to Germany but also include legal clauses such as profitability tests calculated under German GAAP. As a result, a simple structure on a solid Landesbank such as the aforementioned LBBW is an attractive diversification trade.

We see good value in most CoCos with Tier 2 hosts for two reasons. Firstly, we believe that the trigger risk in most Tier 2s is rather remote, in particular for short calls, given that banks must continue to increase their capital ratios in most jurisdictions. Secondly, apart from Switzerland, where they have a specific role in the capital structure, most Tier 2 CoCos appear rather opportunistic or justified by very particular situations. We are not convinced Tier 2 CoCos will play a great role in the target capital structure of European banks. This again mitigates extension risks on these bonds, should their opportunistic goal disappear.

Obviously, Additional Tier 1 (AT1) — though currently close to just 10% of our portfolio — is an area where we spend a disproportionate amount of our research effort. Among the various risks and new risks embedded in these structures, we pay a lot of attention to technical risks and mandatory suspension risks.

Technical risks include the likelihood that an issuer comes back to the market to fill either its 1.5% AT1 buffer or a capital shortfall under a leverage ratio. An issuer like Lloyds that has mostly filled its AT1 buffer as a result of its Enhanced Capital Notes (ECN) exchange is appealing. But technical risks also include the assumed high correlation within the asset class, should there be a failure of one single issue. And technical risks also include the feeling that a lot of investors in the asset class are only chasing yields rather than having a long term view on it. This could partly explain why spread curves have seemed too flat in the asset class. We tend to prefer shorter calls as a consequence.

On mandatory suspension risks, many aspects are at play, notably: the kick-off of the Maximum Distributable Amount (MDA) constraint in 2016; the inflation of litigation costs; the public disclosure or not of Pillar 2 buffers going forward and whether they are part of the combined buffer; and in the recent Deutsche Bank AT1, the additional constraint before 2016 on available distributable items — to name but a few. All in all, there is a great deal of value being offered in these bonds, but this is partially offset by the feeling there are some risks pending that are objectively very difficult to assess properly.

As a word of conclusion, we still see a lot of opportunities in the subordinated bond market, in both legacy and new bonds. On the new AT1s, which has been a hot spot of the market since last year, we invest selectively on bonds where we feel we can fairly assess most of the risks embedded in the prospectuses and we believe we get a decent spread for these risks.

The fund Edmond de Rothschild Signatures Financial Bonds is classified in category 4, in line with the nature of securities and geographical zones in the «objectives and investment policy» section of the key investor information document (KIID). The risks described below are not exhaustive: it is the responsibility of investors to analyse each investment’s risk and to come to their own opinion. Main investment risks: risk of capital loss, sector risk, risk linked to discretionary management, interest rate risk, credit risk, liquidity risk.

A.U.M as of end of May 2014.

17 June 2014. Non-binding document. This document is for information only.

The data, comments and analysis in this document reflect the opinion of Edmond de Rothschild Asset Management (France) and its affiliates with respect to the markets, their trends, regulation and tax issues, on the basis of its own expertise, economic analysis and information currently known to it. However, they shall not under any circumstances be construed as comprising any sort of undertaking or guarantee whatsoever on the part of Edmond de Rothschild Asset Management (France).

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