Call Me Maybe?

Due to inflation and the Fed pivot, many investors are staying away from bonds with longer maturities.  This opens up buying opportunities in Bank Tier 2 paper (“T2s”). It is believed that T2s continue to have high call likelihoods given:

• Amortisation of capital treatment
  • T2 paper becomes expensive subordinated debt with less capital benefits if not called
• Coupon reset feature
  • Investors will receive higher coupons if interest rates are higher on call date
• Signaling and future benchmarking
  • Banks that choose not to call will have to pay a premium for future issuance

Investors can position for yield pick-up through callable T2s which are offering attractive yields of ~ 4-6% p.a.  The risk-reward on the trade is reasonable as the investor is likely left holding 5 year bank paper on a no-call scenario.

Background

In general, banks issue a variety of different papers, broadly categorised into the 4 categories below (in descending order of risk):

a) Additional Tier 1 / Contingent Convertibles (AT1/CoCos)

b) Tier 2

c) Senior non-preferred

d) Senior preferred

Categories (a)-(c) fall under Total Loss Absorbing Capital (“TLAC”).  While AT1/CoCos can be converted or written down to zero without affecting normal operations of a bank, an investor in the rest of the TLAC capital stack is taking risk on bank liquidation/winding up, with recovery being after senior preferred creditors and depositors.  Additionally, issuers may not skip coupons on T2 debt.

Tier 2

Under European Banking regulations, the amount of subordinated debt that qualifies for Tier 2 capital treatment is amortised over the last 5 years to maturity (Source: Article 64 of Regulation (EU) No. 575/2013 (CRR)).

This means that banks who do not call the bonds would be paying the expensive subordinated bond coupons without the debt qualifying for T2 capital treatment.

This gives bank issuers an economic incentive to call the subordinated paper at first call date. Based on current market pricing, investors are being paid the maturity yield to own paper that will likely be called 5 years prior to maturity.

“Investors today are being paid the maturity yield to buy a bond that will likely be called 5 years prior regardless of the interest rate environment”

Callable Bank T2s provide good risk reward in the current market environment.  While the spectre of an outsize move by the US Fed provides headwinds for financial assets in general, downside risk of a long position in T2s is limited by the coupon reset feature and non-deferrable coupons.  Stick to banks with good fundamentals that can withstand an economic downturn.