So who buys banks’ hybrid, or subordinated, debt?
Fixed income funds (FIFs), for a start. And S&P’s just-released report into UK FIFs makes for an interesting illustration of what’s been going on in the sector.
As a reminder, hybrid bonds have characteristics of both debt and equity. Depending on the type sold (Lower Tier II, Upper Tier II, Tier I, etc), the hybrids will constitute different segments of banks’ regulatory capital. The market for the debt has been a bit roiled recently, as bailed-out banks are under pressure not to redeem their callable bonds and/or make certain non-obligatory coupon payments. Nor is the situation being helped by increasing scrutiny of the banks’ overall capital structure.
But back to previous events. Here’s a chart of Merrill Lynch’s sterling bond indices, via the S&P report, which shows total returns of various types of debt in recent years:
You can see that the value of Tier I debt dropped by almost two-thirds over the course of the financial crisis, while Upper Tier II fell by half. Both types of debt have since surged, after banks began buying back their subordinates, and exchanging them for senior bonds, in the spring and summer of 2009.
Of course, if you got out of subordinated debt before Lehman collapsed – and back in before the rally began – you could have made a mint.
As the S&P report notes:
The UK fixed interest sector has seen an extreme dispersion of performance in the past 12 months to 31 May 2009, as especially funds with high yield and subordinated financials exposure suffered in the aftermath of the Lehman Brothers collapse. Very few managers resisted the temptation to buy financials and waited until the end of 2008 to add credit beta, in time for the market recovery . . . The positioning in subordinated financials was a key determinant for fund performance over the past year in the UK fixed interest peer group.
To wit, a tale of three fixed income fund managers:
The AA/V6 rated Old Mutual Corporate Bond Fund had an even more difficult 2008. Fund manager Stephen Snowden believed Lehman Brothers would not be allowed to fail, which hurt the fund severely in 2008 as he held nearly 60% in financial names, much of which was in subordinated bank paper. Security selection and asset-backed securities also weighed on performance. Snowden pointed out that the fund portfolio was valued using what the team believed to be the true market price, not index pricing, which hurt in 2008 but helped in 2009. The fund has recovered strongly in 2009 as risk appetite returned.
And another:
The managers of the AAA/V4 rated Invesco Perpetual Corporate Bond Fund, Paul Causer and Paul Read, were too early in buying into financials, tripling the exposure from 10% in mid-2007 to 30% a year later, with two-thirds held in subordinated issues. This detracted from performance in the fourth quarter of 2008 and in early 2009. However, the fund ranked top decile over the first five months in 2009 as markets recovered. The fund was helped by inflows that the managers invested in the primary and secondary market. The purchases included subordinated bank paper in anticipation of buybacks and exchanges.
And finally:
Ian Spreadbury skilfully navigated the AAA/V3 rated Fidelity MoneyBuilder Income fund through the past two years. He was underweight financials (including subordinated issues) in 2008 and increased the estimated credit beta from 0.8 in Q4 2008 to about 1.2 in July 2009. He has reduced the underweight in financials, with a preference for Lower Tier II and Upper Tier II paper.
As for the outlook for subordinates, there’s precious little in the S&P report other than FIF managers’ general bullishness on corporate bonds.
But then, we knew that already.
Related links:
Delusions, corporate credit edition – FT Alphaville
Frightful fixed income funds – FT Alphaville
Investors to lose from banks converting debt – Telegraph
Life insurers: terrible bond investors – FT Alphaville