Context: The discountedperpetual Floating Rate Notes (FRNs) which we hold in the fundsare legacy capital securities issued bybanks and insurers under previous regulatory regimes, these will become inefficient capital to maintain for issuers and we can expect them to be recalled by 2022 for Banks and 2026 for Insurers.
Impact for the fund:The market is starting to price the loss of eligibility of the legacy bonds, we experienced strong capital gains and we expect this trend to continue over the next months.
Exposure to legacy securities in all three funds
Legacy securities – background on regulation
- Issued by banks and insurers under previous regulatory regimes (Basel I and II for banks, Solvency I for insurers).
- As a reminder these instruments are issued as they are eligible as capital and cheaper than equity (cost of equity of c10% compared to issuing AT1 CoCos at 4-6%) and not for funding purposes or to take on additional leverage. As these increase banks/insurers’ capital stacks they make financials safer, unlike corporates that issue debt to incur leverage and increase default risk. Basically no incentive to keep these instruments unless they retain capital value.
- For banks – under Basel III European banks are allowed to count these old bonds as capital until Dec-2021 (grandfathering period). Additionally, banks have a limit on how much legacies can count as capital – declining at 10% per annum until Dec-2021, so as time passes, instruments become more inefficient.
- For insurers – under Solvency II Insurers are allowed to count these old bonds as capital until Dec-2025 (grandfathering period). 100% of legacies count as capital until Dec-2021, no gradual phase-out.
Legacy securities – Instrument types
- A lot of different types of bonds, as issued as back as 1984 up to the early 2010s (until AT1 CoCos and new-style insurance RT1s started to be issued). The features of the instruments reflect regulators’ criteria at time of issuance under the applicable regulatory regime. Hence these have changed significantly through time, explains why no two legacy bonds are the same.
- In terms of different instrument types (key instruments)
- Legacy FRN perpetuals (similar to the Santander and Commerzbank called): these are trading well below par due to relatively low coupons, periodically callable at par with floating-rate coupon structures. Due to the FRN structure, highly attractive to mitigate interest rate risk in a diversified bond portfolio (benefits from higher rates)
- Make-whole bonds – where the redemption price is based on a specific yield. For example, the Commerzbank 8.151% callable in 2029 can be redeemed early upon loss of regulatory value (which will occur in Dec-2021) at a price where the yield is the US treasury rate + 50bps, equivalent to a 140% price under current market conditions
- Regulatory par call bonds – where the issuer has the option to redeem bonds at par before the first call date upon loss of regulatory capital at par. Here clearly for bonds trading well above par there is downside risk, and for instruments trading below par there is upside risk
- Insurance Solvency I perpetuals – mostly fixed-to-floating issued ahead of Solvency II as they count as capital until Dec-2025. Typically callable ahead of the end of the grandfathering period, for example Groupama 6.375% Perpetual callable in 2024. Carry no extension risk as ineligible afterwards.
- Deep expertise is required to analyze these securities given the wide range of structures, different terms and conditions that can greatly impact the upside/downside for investments, and need to understand the regulatory backdrop as well as changes.
Legacy securities – New bonds are the old bonds
- Regulation is constantly evolving and therefore some AT1 CoCos are becoming the new legacy securities.
- In Switzerland low trigger instruments (with a conversion/write-down trigger below 7%) are ineligible after their first call date. Therefore on instruments with a trigger below 7% there is no extension risk – as it loses capital value if not called.
- In the Euro Zone new changes in regulation (called CRR2) will disqualify certain bonds, such as those issued under foreign law (issued under New York law for example), and these are grandfathered until June-2025. Again, extension risk becomes very limited post 2025 as these will no longer be eligible as capital.
Legacy securities – why invest?
- Attractive instruments to hold given a wide range of different structures, such as FRNs to manage interest rate risk, long-call perpetuals provided attractive running yields, etc.
- Regulation is the clear catalyst, whereby these instruments are increasingly inefficient as capital, as will become 100% ineligible in Dec-2021 (banks) and Dec-2026 for insurers. As we progress through the grandfathering period we expect issuers to take-out old-style instruments and issue new-style bonds. We expect banks to be more active in the near-term as the end of the grandfathering period is nearer and bonds are increasingly inefficient. Nevertheless we are also seeing insurers already optimizing their capital structure.
- Therefore, these instruments provide “free optionality” for bondholders upon a take-out, as we have seen with Banco Santander, Commerzbank and Ageas very recently. All three we trading below par and either outright called at par or tendered above market levels.
- For bonds trading above par, those with make-whole features remain highly attractive, as these will be taken out at significantly higher prices.
- Despite the upside potential overall in the asset class, investors need to be conscious of the downside risk embedded in some instruments – and security selection is key. For example Lloyds 12% perpetual notes callable in 2024 offer a c7% yield in USD, however as these contain a regulatory par call and are trading at c122%, the yield upon a reg par call in Dec-2021 is only 1.4%, lower than an equivalent US treasury bond.
- This is why investors need deep expertise on both regulation and analyzing bond structures (especially understanding the terms and conditions in the prospectus) on top of the in-depth bottom-up analysis of the issuer, to gain exposure to the asset class and find the best value across the capital structure.