Over the past year, a recurring theme of our weekly articles has been the interplay between inflation, central bank policy and economic activity. This clearly remains a topic at the forefront of most investors’ minds. However, as we have also alluded to, the upshot of the steepest rate hiking cycle in decades is the yields that bonds now offer.
Higher interest rates result in a number of significant ramifications for investors, businesses and households. The era of close to zero percent interest rates and quantitative easing can be described as a tax on savers in order to incentivise investment with the aim of boosting output. After a decade of receiving little interest on savings and bonds, the recent rate hiking cycle has resulted in lower-risk investments now offering some attractive yields. Given longer-term dynamics of demographics, high levels of government debt and technological advancement; there is every reason to believe that locking in some of the higher levels of interest might be a prudent thing to do over the medium term.
However, the recent woes in the banking space have given some pause for thought. Generally, investors should expect a higher rate of return owing the equity of a company, rather than their bonds. The reason being that bondholders have a claim on assets if that said company’s fortunes decline and result in bankruptcy. This would typically wipe out equity investors but give bond investors the recovery value of assets that remain. The controversy surrounding the recent implosion of Credit Suisse (CS) has just flipped that notion around. When the Swiss government and regulator brokered the deal for UBS to take over CS, they allowed UBS to recognise heavy losses which enabled them to wipe out subordinated bond holders. Furthermore, the deal was structured as an all-share transaction and saw UBS pay CS shareholders a total consideration of CHF 3 billion. This episode thus raises the following question, if subordinated bonds do not offer preferential treatment to equity holders, what is the point in holding them in the first instance?
The current structure of subordinated bank debt can trace its roots to the aftermath of the global financial crisis. At that time, most banks were at risk of going under. Global governments feared that without intervention, this could result in a depression akin to the one faced in the 1930’s. As such, governments provided emergency lending and took stakes in major banks which effectively bailed them out. This sparked the ire of the wider population, as the bankers who brought this crisis upon them, did not face enormous consequences. Furthermore, the majority of bondholders were made whole. This opted a rethink of regulation in terms of bank structures to ensure that taxpayers would not be on the hook for any future bank failures.
The regulatory changes that followed, resulted in banks requiring a lot more capital and issuing specialised new forms of debt. Furthermore, larger banks would have to undergo severe stress tests which would set their capital requirements. If banks failed these tests, they could be subject to dividend suspensions. While there are several forms of subordinated debt that banks issue, I will focus here on Additional Tier 1 (AT1) Contingent Convertibles (quite the mouthful, I know), which, in the case of CS, were wiped out. As the name implies, these bonds would typically convert, contingent upon capital levels or other clauses stipulated in the bond documentation. Those that CS issued had features known as permanent write-down clauses, while the majority of other banks and regulators, prefer either temporary write-downs or equity conversion clauses. This clause was an important feature in terms of how the deal was structured. However, despite this clause, most regulators came out and sternly rejected the approach taken by the Swiss government and regulator.
Earlier this week, Bank of England Governor, Andrew Bailey, was questioned in the Treasury select committee about the recent banking woes. When questioned about AT1 bonds, he said that in Britain bond holders would not face similar treatment. Specifically, he noted that “in any resolution we will always abide by the code of hierarchy because that’s a cardinal principle”. It is also worth noting, that the Financial Conduct Authority has specifically set out restrictions of distribution for this type of debt for retail clients.
While regulators are keen to brush this episode as an exception, not the rule, in the immediate aftermath there are some important lessons we can draw. The cardinal principle of investing remains intact. However, as with every contract, it is important to read the fine print. Investors may have lost confidence in investing in these type of securities, but further efforts will be taken to shore up confidence, although this is likely to take some time. If the cost of debt for banks remains higher as a result of this episode, this will only serve to tighten financial conditions further, making it harder for central banks to target inflation as the economy could weaken more sharply than anticipated as result of the higher cost of financing.
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