Saturday, May 21st, 2022

Subordinated bonds: the five things to know

In this final part, we try to focus on 5 elements that must be carefully evaluated before investing in these bonds.

1- Subordinated bonds are complex instruments and often difficult to frame

The technical characteristics of these securities are explained in the issue prospectuses or other documents, very often written in English and with terminology that refers to civil law and banking regulations. In a certain sense, to fully understand the characteristics of these securities, it is necessary to have a clear understanding of the operating logic of credit intermediaries and central banks. The role of the subjects in charge of banking supervision is, in fact, very important to fully understand these tools; consider that the exercise of the early redemption clauses and, in the case of Tier 3 bonds only, the repayment of the capital at the final maturity must be specifically approved by the central bank on which the issuer depends.

The real risk to which one is exposed is not always clearly deducible from the documentation and the actual characteristics of the obligation may differ from those assumed based on summary information. The same division between the four typologies we have analyzed may not be immediate. Furthermore, even for the same type, two different bonds may have different characteristics and risks.

2-Their credit risk is high

In general, all subordinated bonds carry a greater risk of loss of principal and interest than senior (unsubordinated) bonds. In the event of bankruptcy or failure, the loss that the investor can suffer is always high and very often tending to 100% of the invested capital, since the other creditors are privileged and the equity buffer intended to mitigate the losses of the lenders is rather limited (too limited, as we have already said).

In particular, the credit risk is very high for Tier 1 bonds and for some Upper Tier 2 bonds, which may provide for the cancellation of coupons and part of the capital, without having to lead to real insolvency of the issuer.

3-They are difficult to assess, especially if the repayment date of the capital is uncertain (“extension risk”)

Many subordinated bonds do not have a real maturity but provide for the possibility of being called by the issuer on certain dates (“call” option). If until the end of 2007 it was customary to recall bonds on the first call date foreseen by the prospectus and all investors considered the call date as a real maturity, the financial crisis that has hit the whole planet since the end from 2007 to today has changed this state of affairs. Some issuers have decided not to repay the bonds early (as was the case for Credito Valtellinese and Deutsche Bank) despite being able to do so; in other cases, substantially insolvent companies such as some English or German institutions, saved in extremis by public intervention, not only did they not redeem the bonds on call, but they also warned investors that they will have to suffer capital losses, even though there has never been real insolvency. In general, the so-called “extension risk”, that is the uncertainty about the actual maturity of the investment, has grown dramatically, especially for instruments issued without a real maturity (many UT2s and all T1s). In short, it has become very difficult to estimate the return on investment, since its maturity is not known with certainty. that is, the uncertainty about the actual maturity of the investment, especially for instruments issued without a real maturity (many UT2s and all T1s). In short, it has become very difficult to estimate the return on investment, since its maturity is not known with certainty. that is, the uncertainty about the actual maturity of the investment, especially for instruments issued without a real maturity (many UT2s and all T1s). In short, it has become very difficult to estimate the return on investment, since its maturity is not known with certainty.

The investor in a Tier 1 security, in particular, must now be aware of making a long-term investment, very similar to an equity investment.

4-Their liquidity is scarce

Even more than the usual corporate bonds, subordinated bonds can be really difficult to buy and sell, as each security makes its history as, unlike the unsubordinated paper, each issue has peculiar characteristics that distinguish it from the others. In times of high uncertainty, as has been the case in the last two years, factors such as extension risk end up further complicating the task for market makers.

5-The risk is difficult to diversify

The recent past has shown how the price of these bonds, in phases of extreme turbulence, tends to decline without much reference to the specific characteristics of the securities and issuers, making it extremely manage and diversify risk. Having a broadly diversified portfolio is not enough to be able to control risk. Furthermore, due to the magnitude of the fluctuations, the risk involved in this type of investment is more similar to that of an equity portfolio (especially for Tier 1 securities) than that of a corporate bond portfolio.

 

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