Subordinated debt: Investor demand swamps bank capital
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Subordinated debt: Investor demand swamps bank capital

Crédit Agricole attracts 900 orders; when everyone is buying, aficionados suggest time to sell.

If any evidence were needed that the chase for yield is alive and well and headed further down the capital structure it came with Crédit Agricole’s debut AT1 trade in late January. The French bank issued a $1.75 billion perpetual non-call 10 bond that offered a coupon of 7.875%. It attracted an enormous $25 billion of orders from 900 accounts – something that would have been unthinkable for a bank capital trade until very recently.

Investor reaction seems to have left many in the market baffled, but the asset class is rapidly moving from being demand-constrained to just the opposite despite the surge in issuance predicted over the next 12 months. "This is what bank capital is going to look like in the future. It is too big to ignore any more. You have to have a view on this asset class," says Peter Bentley, head of UK and global credit at Insight Investment. "We can construct a scenario where there will be €125 billion to €140 billion of contingent convertible (CoCo) issuance over the next three years."

Little value left

Just as many real-money investors are getting their heads around new bank capital securities, other credit specialists point out that the big returns in this market might have already been made. Cairn Capital, a London-based credit asset management and advisory firm, recently closed its dedicated subordinated financials fund, stating that there was now attractive value in only a limited number of subordinated financials bonds on both an absolute and relative basis. The fund generated a net return of 64.92% from launch to close – a period of just over two years.

"We have managed dedicated legacy subordinated financials mandates since 2009 and launched the fund in October 2011 at the height of the systemic crisis when we saw deep value even though others were exiting," says Philippe Kellerhals, senior portfolio manager at Cairn. The firm has now closed the fund as it believes that this level of return is no longer possible.

Andrew Jackson, chief investment officer at Cairn Capital
Andrew Jackson, chief investment officer at Cairn Capital

"Our focus was on legacy hybrid capital instruments," Andrew Jackson, chief investment officer at Cairn Capital tells Euromoney. "The fundamental tenet was that these instruments would go under Basle III. When we launched the fund we thought that LME (liability management exercises) would be a big theme with the Basle III window closing, and since then there has been a rush by banks to undertake all the LME that they could that was faster than we thought it would be. So to all intents and purposes this process is largely complete now, but that is not to say that there is not further price appreciation to come." So have investors now sizing up the opportunities in subordinated financials already missed the boat? Or, more specifically, does the risk-reward equation still make sense? "This was a dedicated fund for old-style instruments. The new-style instruments are not going to generate the 15% to 20% returns that we stated we were looking for," says Jackson. However, he adds that: "There are still plenty of interesting things to look at in subordinated financials."

The risk to the market is that it becomes flooded with nonspecialists desperate for yield that do not understand the risks that they are taking on and whose presence depresses returns.

Initial price guidance for the Crédit Agricole deal was between 8.125% and 8.375%, but the final price was 25 basis points below even the bottom of that range. This for a deal with an unusual dual-trigger whereby principal write-down occurs if the CET1 ratio of the Crédit Agricole Group falls below 7% or the CET1 ratio of the subsidiary via which the bond was issued falls below 5.125%. Investors seem to have made no distinction between Crédit Agricole’s high 7% trigger and the December Société Générale AT1 deal that carried just one lower trigger at 5.125% of CET1 but priced at the same level.

However, the attractiveness of financials – both senior and subordinated – to fixed-income investors is such that these kind of anomalies might become commonplace. "Different industries are now at different points in the cycle: industrials and general corporates are in a phase of expansion with M&A and shareholder-friendly actions, while financials are still in a phase of repair," says Richard Ford, head of European fixed income at Morgan Stanley Investment Management. "There is a clear linkage between economic growth and the stability of the banking system so it is very difficult for the cycle not to eventually converge, which it will do in the short to medium term. But in the meantime financials will continue to be attractive to fixed income during this phase of repair as the benefit goes to bondholders rather than shareholders."

However, if you are buying a deeply subordinated bond that carries the risk of permanent write-down that will clearly not always be the case. "The new-style instruments are interesting and different, although the risk they represent is sometimes worse than equity," points out Cairn’s Jackson. "I understand why people are launching dedicated funds for this as these are investments that need to be managed by specialists." But he adds the following caveat: "Our fund was set up on the premise that these instruments would do well irrespective of the markets, and that is not the case for contingent capital instruments."

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