Subordinated bonds
Restating conviction - Capital Securities theme | 19 November 2015
CIO WM Research
Rebecca Clarke, Credit Strategist, rebecca.clarke@ubs.com; Frank Sileo, CFA, Taxable Fixed Income Strategist, frank.sileo@ubs.com
• We remain positive on the outlook for continued strong
performance of the Capital Securities theme, and maintain our
constructive view on the credit quality of financial issuers.
• Over it's 20-month life, the Capital Securities theme's 10.6%
return since inception has doubled that of its benchmark (the
broader investment grade index)
• In our last update (May 2015), we moved to include retail
USD 25 par preferred securities in our investable universe, and
switched to an index which included these.
• Our three-part rationale for including retail preferreds was
based on our benign expectations for US interest rates, our
desire to broaden the base of investable securities, and to
increase our allocation to bank and insurance issues.
• Although we maintain a Neutral recommendation on the
broad retail preferred market in our House View publication,
we continue to recommend financial sector capital securities
for the yield advantage of the asset class relative to senior
unsecured investment grade securities.
• The fundamentals of bank and financial sector credit quality
remain at very sound levels and are likely to remain wellanchored due to new regulatory requirements and oversight.
Bank capital structure under Basel 3
Senior debt
Secured liabilities
Including repos, the LTRO and covered bonds
Deposits, derivatives and swap
liabilities
Can rank higher than senior unsecured bonds in
countries with bank resolution regimes
Senior unsecured bonds
Fixed maturity bonds, coupons to be paid
Subordinated debt
Tier 2 bonds
Fixed maturity bonds, coupons to be paid,
subordinated to senior debt
Hybrid debt
Tier 1 hybrid securities
Perpetual, coupon payments optional and noncumulative (incl. preferred shares)
Tier 1 contingent convertibles (CoCo)
Loss absorbing following trigger event; principal
write-down or conversion into common shares
Core equity capital
Since we introduced our recommendation on financial sector capital
securities in February 2014, and since our last update in May 2015,
the amount of new issuance of USD 1000 par capital securities by
US banks has continued to decline relative to 2014 and 2013 levels
due to the fact that US banks are much closer to completely filling
their Additional Tier I capital buckets. Since the start of the year, the
US banks of USD 50bn or more in assets have issued 22bn in new
USD 1000 and USD 25 par preferreds.
European banks have been more prolific, with EUR 33.5bn in new
CoCo AT1 issues in the year to date, with debut CoCo bonds from
Mandatory convertible bonds
Common shares
Source: BIS, UBS CIO WMR
A version of this report is available with specific
security recommendations for US onshore
investors. For a copy, please consult your UBS
Financial Advisor.
This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and
disclosures that begin on page 8.
Subordinated bonds
ING Group, Royal Bank of Scotland, and Standard Chartered. In addition, we have seen new USD and EUR denominated subordinated
bond (Tier 2) issuance from both US and European banks. We continue to see out-performance for USD financial sector capital securities,
including US bank subordinated and preferred issues and European
bank subordinated and legacy Tier 1 issues relative to the broader US
investment grade index.
Our new performance measurement index is working out well
In May 2015, we shifted direction slightly, by adding in a component of USD 25 par denominated retail preferred securities. We originally focused exclusively on the institutional USD 1000 par securities market, primarily because they exhibit better liquidity and greater
price stability. However, in recent years we have seen US money center
and large regional banks issuing preferreds in both the retail USD 25
par market and the institutional USD 1000 par market, with relatively
large-sized issues in both cases.
By adding a component of retail preferreds, we have significantly
broadened the scope of the Capital Securities theme, which centers on capturing higher yields and greater capital appreciation from
investing in financial sector capital securities in a transitional regulatory environment. We still see good prospects for new issuance of both
bank and insurer Tier 1 and Tier 2 capital in response to Total Loss
Absorbing Capacity (TLAC) and Basel 3 capital requirements for US
and European banks, and in response to coming regulatory changes
under Solvency 2 for European insurers.
Simple insurance capital structure
Policyholders
Senior debt
Secured bonds
Bonds secured with insurance policies
Senior unsecured bonds
Final maturity, mandatory coupons,
subordinated to policyholders' claims
Hybrids
(Un)dated
Tier 2 bonds
debt)
(No) final maturity, deferrable, cumulative
coupons, minimum 5 year non-call period
Contingent capital notes
Loss absorbing following trigger event; principal
write-down or conversion into common shares
Tier 1 securities
Perpetual, coupon payments optional and noncumulative (incl. preferred shares)
Shareholders' equity
Common shares
Retained earnings
Source: NAIC, UBS
The largest US insurers are also subject to evolving regulatory capital requirements due to their status as non-bank Systemically Important Financial Institutions (SIFI's, affecting MetLife, Prudential Financial, and AIG). The legacy, non-compliant Tier 1 securities of banks
and insurers also continue to offer solid yields for existing holders,
while some issues with first call dates farther in the future may still
offer attractive purchase options on a yield to first call basis. We view
it as highly likely that these securities will be called.
How has performance been so far?
The total return on the Capital Securities Theme has been measured
using the recommended indicies; initially BofAML COCS (100% capital securities) and since May the BofAML COPS (blend of retail preferreds and capital securities) against the broader benchmark investment grade master index (BofAML C0A0). From inception to date, the
theme has returned 10.6%, versus the benchmark return of about
5.1%. The outperformance has come from the higher coupons on
the recommended indicies relative to the IG master, while spreads
have narrowed on the index and widened on the IG master due to
credit spread widening in non-financial sectors. Credit factors also
support the performance, with banks and financial issuers reflecting
their lower volatility and higher credit ratings relative to non-financial issuers where issues such as re-leveraging, shareholder friendly
policies, and fundamental credit weakness in energy, basic materials,
and commodities are having primary and derivative effects on credit
spreads in these are related sectors.
UBS CIO WM Research 19 November 2015
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Subordinated bonds
Sticking to our financial sector roots
Our preference for financial sector capital securities is based on our
constructive view of the fundamental credit strength of bank and
insurance issuers in both the US and Europe. Most of these issuers
have largely completed the restructuring programs implemented following the financial crisis. While some larger European issuers still
have significant work ahead to complete the run-off and restructuring of businesses (eg. RBS, Deutsche Bank, Barclays and Credit Suisse)
they have made significant headway in building the required capital
under Basel 3. Banks and insurers and large cap diversified financials
are holding record levels of equity and liquid assets. By and large, they
have lowered leverage while the slow but steady recovery of the US
economy and the Eurozone and UK have helped securities valuations
recover and credit losses on loan portfolios are at very low or improving levels.
USD 25 par preferred allocation added in May 2015
With our May 2015 report, we introduced an alternative index to track
the performance of the theme: the BofAML US Preferred, Bank Capital & Capital Trust Securities Index (C0PS). This all investment graderated index includes about 30% market weight of USD 50 and USD
25 par preferreds, in addition to 70% market weight USD 1000 par
preferreds, Tier 2, and insurance hybrids that are similar to the Capital Securities index (C0CS) we originally used. We prefer the new
index due to its significantly higher banking component (about 58%
of market weight of securities), its significant insurance and diversified
financial services exposure (about 28%), and its lower component of
non-financial sector issues (about 14%).
Comparison of the indices
(index characteristics of the blended preferred and capital securities index C0PS
relative to the institutional capital securities index C0CS and relative to the broader
investment grade index C0A0)
As of 11/17/2015
C0PS
Number of Issues
212
Amount Outstanding (USD bn)
164,504
Market Value (USD bn)
172,392
Option Adjusted Spread (bps)
216
Par Wtd Price (%)
104.8
Mkt Wghted Rating
BBB
Yield to Worst (%)
4.60
Modified Duration to Worst (Yrs
5.86
Mkt Weighted Coupon (%)
6.40
C0CS
91
72,879
77,409
253
106.22
BBB
4.37
5.44
6.64
C0A0
6,907
5,178,833
5,348,090
162
103.27
A3
3.50
6.65
4.39
Source: BofAML, UBS CIO WMR as of 17 November 2015
What are financial sector capital securities?
Capital securities describes the broader asset class of banks, insurance
companies, and selected non-financial corporate securities that serve
as a source of capital after common equity is depleted. For financial
sector capital securities, Tier 1 capital securities, support the issuer's
capital needs when it is still a going concern. We include both USD
25 par and USD 1000 par issues of preferreds in this definition. Tier
2 securities generally are tapped in a liquidation of the issuer to serve
as a source of capital to support more senior creditor claims.
We continue to emphasize USD 1000 par capital securities for
their better price stability and greater liquidity
Institutional capital securities are traded in the over-the-counter USD
1000 par market, including both Tier 1 and Tier 2 capital issues.
These USD 1000 par issues are sold through syndicates to institutional
investors when launched. The combined USD denominated market
of institutional and retail capital securities is nearing USD 750bn. We
still favor the institutional market, as we feel institutional investors will
more consistently invest for yield and total return purposes, such that
prices are likely to be less volatile, while the markets for these securi-
Related reports:
An update on the Capital Securities
theme - 20 May 2015
An update on the Capital Securities
theme - 10 November 2014
Capital securities redux - stability
carries on - 28 August 2014
Opportunities in financial sector
capital securities - 28 April 2014
Opportunities in financial sector
capital securities - 20 February 2014
UBS CIO WM Research 19 November 2015
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Subordinated bonds
ties are deeper, and more liquid. While we continue to see the USD
25 par retail preferred market as susceptible to some volatility due to
investment flows and ETF positioning, we expect the asset class to
provide attractive risk-adjusted returns over a longer time horizon.
Basel 2 & 3 comparative capital structures
Buffers
Sifi (1-2.5%)
Countercyclical (2.5%)
We see room for some tactical positioning in retail preferreds
We like the structural diversification of the retail preferred market,
where issues can be categorized based on their coupon and call
features in addition to issuer and rating differentiators. Given the
exchange-traded market structure of retail preferreds, as well as the
lower sums needed to invest, we believe investors can tactically position their portfolios to capture the benefits of new issue spread compression.
The deliberate move into smaller retail preferreds will also allow the
investor to gain exposure to a greater number of issuers, thus increasing diversification. In addition, investors can use floating or fixed-tofloat preferred share structures to reduce interest rate sensitivity, and
to modify overall portfolio interest rate exposure. This is true as well
for fixed to float and pure floating rate preferred shares in USD 1000
par size, but it may be easier for retail investors to diversify issuers in
fixed to float and floating rate structures due to the lower dollar size
commitment needed.
Tier 2 capital
Tier 2 (2%)
Tier 3 capital
Tier 2 capital (4%)
Tier 1 capital (8.5%)
Lower Tier 2 (2%)
Additional
Tier 1 (1.5%)
Upper Tier 2 (2% )
Conservation Buffer
(2.5%)
Tier 1 capital (4%)
Innovative Tier 1 (0.6)
Non-innovative Tier 1
(1.4%)
Equity and retained
earnings (2.0%)
Equity and retained
earnings (4.5%)
(Minimum Common
Equity Tier 1)
Basel 1 / 2
Basel 3
Source: BIS, UBS CIO WMR
Some structural recommendations for both retail and institutional Tier 1 securities
We maintain our preference for certain types of structures in Tier 1
capital securities. These include preferreds, European legacy Tier 1
bank issues, and insurance Tier 1 hybrids from both US and European
issuers. All are issued as either callable perpetuals or as longer dated
maturity callable Tier 2 securities. Insurance hybrids and bank TruPS
fit into the longer dated maturity callable Tier 1 category, but most of
these have been called, as their Tier 1 capital status is now down to
50% principal credit, and will phase out of Tier 1 capital completely
in 2016, for US banks.
Relative performance of the indices
(C0PS relative to C0CS and C0A0, total return % with
indices rebased to 100 at 12/31/2013)
114
112
110
Total return index
In the Tier 1 bank capital arena, we favor legacy (non-CoCo) Tier 1
issues and dated Tier 2 issues of European insurers and US bank Tier 1
(Basel 3 compliant) perpetual, non-cumulative preferreds for the best
total return and yield potential relative to senior bank bonds. Within
the perpetual Tier 1 capital class, we favor those structures with less
interest rate sensitivity, and the highest possible potential of being
called at their first call dates, and/or interest rate protection if these
are not called at first call dates.
108
106
104
102
100
98
96
We continue to favor fixed-to-float rate structures with the highest
credit spread available on their floating rate component, as those with
a high back end spread are more likely to be cheaper to replace at
call dates. Moreover, the form of Basel 3 compliant Tier 1 bonds and
preferred shares now requires that these issues not be callable for at
least the first five years. We are seeing banks and insurers issue noncall five year and non-call ten year issues more often.
94
92
2/20/2014
6/20/2014
10/20/2014
2/20/2015
6/20/2015
10/20/2015
US Preferred Bank Capital&Cap Trust (C0PS)
US Corp Master (C0A0)
U.S. Corp All Capital Securities (C0CS)
Source: BofAML, UBS CIO WMR as of 17 November 2015
UBS CIO WM Research 19 November 2015
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Subordinated bonds
What are the return expectations?
We maintain our return expectations on the theme as the coupon on
the securities plus a stable credit spread environment, such that our 6
month return expectation on an absolute basis is 3%, and our positive scenario is for further spread tightening in capital securities relative to the broad investment grade credit spread (or widening in IG
spreads). Our anticipated performance versus the IG benchmark index
is plus 1% with upside potential based on spread movements reflecting better credit quality in financials. We recommend that investors
take advantage of any price weakness in capital securities to increase
or tactically improve positions, focusing on fixed to float securities
with a high fixed component and high floating rate credit spreads,
which exhibit lower price volatility in a rising rate environment, and
where floating rate spreads are high, increasing the probability that
these are called at first call dates, and increasing the attractiveness of
the securities as a floater if they are not called.
What is the outlook for the theme?
Our current House View forecast for US interest rates envisions a more
moderate and orderly pace of interest rate increases. We believe this
will decrease the likelihood of widespread selling in the retail preferred
market akin to what we saw during the "taper tantrum" in 2013, or at
least make the duration of any sell-off relatively short-lived. We have
seen preferred securities outperform in the year-to-date and continue to view solid income and stable credit spreads as likely to lead to
ongoing good performance for capital securities including preferreds
in the near-to-medium term supported by:
Year to date price volatility of C0PS and C0A0
• Regulatory capital requirements continuing to phase in, with the
fully implemented Basel 3 capital requirements largely met by the
large regional and money-center US banks, with comparable capital
positions among the larger European banks under our coverage, and
relatively long phase-in period for Solvency 2 for European insurers.
Capital requirements are increasing as the capital conservation buffer
and full global systemically important bank buffers phase in, and new
issuance and fine tuning will continue.
Source: BofAML, UBS CIO WMR as of 17 November 2015
112
Price over par
110
108
106
104
102
100
98
12/31/2014
3/31/2015
6/30/2015
9/30/2015
US Preferred Bank Capital&Cap Trust (C0PS)
US Corp Master (C0A0)
U.S. Corp All Capital Securities (C0CS)
• Pricing on new issues is improving as rates rise, with higher recent
fixed rate components on fixed to float preferred issues, and more
generous floating rate credit spreads due to higher spreads overall as
well as negative swap spreads.
• Bank credit ratings are more stable, following S&P and Moody's
recalibration of ratings earlier this year to reflect removal of government support notching for US and European banks.
How to invest?
For those investors seeking the diversification and active management
of a fund, we recommend investors consider closed end funds which
focus on institutional capital securities. These funds generally invest
in capital securities and retail preferred shares, with the goal of high
yield and some capital appreciation.
UBS CIO WM Research 19 November 2015
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Subordinated bonds
What are the risks?
We already have credit and equity market evidence of the fundamental improvement in the financial sector, particularly in banks, as
seen in the performance of their equities and credit spreads in 2013.
We will emphasize bank issues in our recommendations, as we see
these as the most likely to generate the returns we expect. The rules
themselves, under the Basel 3 framework, are already being instituted in the US and Europe, and in the larger and more developed EM
countries. For European insurers, Solvency II requirements begin their
implementation in 2016, and we see market pressure for these companies to comply early with most having already initiated the process.
Extension risk - A main risk for investors is extension risk. If securities
are not called at their first call date, they may remain outstanding for
some time, affecting returns and potentially causing realignment of
prices (downwards) in recognition of the longer maturity profile. This
could happen if a bank determines that a security is a source of reasonably priced subordinated capital and retains in its capital structure
on its original terms.
We believe this risk is manageable because we expect most old-style
Tier 1 and 2 securities to be called at their first call date, mainly due
to economics. These securities are transitioning out of Tier 1 status,
and most banks can issue lower cost debt as senior debt and have
good access to markets. Old style Tier 1 securities will generally phase
out from Tier 1 to Tier 2 status, and then from Tier 2 to senior status. We think most banks are likely to issue fresh, Basel 3 compliant
securities to fulfill the specific functions of Tier 1 and Tier 2 in their
capital structures. Bank issuers may write into these new securities
terms which enable these to adapt to rising capital standards over
time, as we think it likely that for the largest global banks, capital and
leverage requirements will be more likely to rise from current levels
than to decline.
Regulatory par calls - We see limited scope for further regulatory
par calls under Basel 3 for the banks, as most banks in Europe and
the US have only a limited number of legacy TruPS or Tier 1 securities
(that are non-CoCo for European banks) remaining on their books.
However, we see increasing room for calls on those non-compliant
securities currently outstanding that are beyond their first call dates.
This would include the remaining TruPS outstanding, as these will no
longer receive any credit as Tier 1 capital next year (from their current 50% of principal credit position). European banks have a slightly longer phase out period, until 2022 for their grandfathered Tier 1
securities, but these lose 10% of par value credit for the total principal
balance of legacy Tier 1's each year from this year through 2021.
Price volatility - Given the House View outlook for rising interest
rates, capital securities may be more volatile in the near term in due
to their subordinated status. That said, we expect capital securities to
outperform senior unsecured bank issues due to the lower coupon
and longer average duration of the senior bank issues. We also expect
lower price volatility in the blended index of institutional capital secu-
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Subordinated bonds
rities and retail preferred securities relative to the pure retail preferred
securities market.
Interest rate risk - A good number of the newly issued Tier 1 securities may be non-callable for 10 years. A security issued at today's rates
that is fixed and non-callable for ten years may be subject to higher
price risk as interest rates gradually rise. To mitigate this risk, we will
look for compliant fix to float structures, as well as higher coupon
fixed structures as the latter offer some additional credit spread which
could potentially offset some of the yield variance due to rate changes
from the security's issue date.
UBS CIO WM Research 19 November 2015
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Subordinated bonds
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