Hunting for yield on safer ground
As yields continue to be suppressed across most fixed income assets, alternative assets have increasingly caught investors’ attention. Subordinated debt offers an attractive balance of risk and reward – and has an appealing combination of characteristics, including attractive yield, investment grade issuers, liquidity and the ability to absorb the impact of interest rate increases.
Nomadism, originating from the Greek word « νομάς », meaning roaming about for pasture, is by far the oldest human subsistence method and the most efficient strategy for exploiting scarce resources. Within fixed income markets, the equivalent search for resources, or yield, is not as intense but requires strategic thinking.
Over the past few years, investors have turned to riskier strategies as the European fixed income markets continue to provide low or negative yields due to supportive monetary policy from the European Central Bank and volatility levels at historic lows. However, the relatively new asset class of subordinated debt offers an attractive balance between risk and return, and a range of positive characteristics.
The European subordinated bond market is more than twice the size of the senior high yield market and offers a variety of investment instruments, namely contingent convertibles and Tier 2 debt issued by banks, Tier 1 and Tier 2 debt issued by insurance firms and hybrids issued by non-financial companies. These instruments rank lower in the hierarchy of debt owed to a company’s shareholders and are exposed to specific risks such as coupon deferral or cancellation and loss absorption, but they are issued by highly rated companies and compensate investors with higher yield.
The subordinated debt universe is characterised by high issuer ratings, with 95% of issuers rated as investment grade. This comes as no surprise since banks re-capitalised and de-risked by doubling their core equity over the past 10 years, while at the same time decreasing risk-weighted assets and non-performing loan ratios. Within insurance companies, improvements in capital composition and solvency ratios have also led to rating upgrades.
The asset class offers attractive relative value versus high yield and mispricing opportunities as there is much higher spread dispersion when compared to senior investment grade bonds, with the added benefit of lower duration exposure. Finally, subordinated bonds can absorb the impact of interest rate increases due to their embedded high-risk premia and therefore, perform well compared to other fixed income strategies in periods of rising rates.
As with the nomadic lifestyle, the subordinated debt asset class does not come without risks, but compensates investors by providing diversification within a fixed-income portfolio, high carry (high yield like) with a solid credit and liquidity profile, and a long-term story driven by the recapitalisation of financials and supported central bank activity.
Michalis Ditsas, fixed income investment specialist at SYZ Asset Management
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