La Française: A topical overview of the subordinated debt market

October 1, 2021

By Jérémie Boudinet, Credit Fund Manager, La Française AM

Market reaction to Covid-19

This market segment was at first heavily impacted, with drawdowns reaching as much as c. 30%, but the recovery has been just as strong, thanks to the early support from governments and regulators, which knew that financial institutions were needed to be part of the solution for the Covid-19 crisis. The only counterparty to all the financial support banks received was the temporary suspension of dividend distributions, which actually was good news for bondholders, as capital strength was being preserved!

Moving forward, a positive outlook on subordinated debt instruments

The financial subordinated debt space is now mature in Europe, and we expect new bond supply to be used almost only for refinancing purposes. At the same time, the riskiest layer of bank subordinated debt, Tier 1 bonds (aka CoCos), is attracting more and more demand worldwide, as the product is seen as less volatile than in the past and thanks to its average yield of c. 3%, which is quite rare in the current market environment. In our view, financial subordinated debt should represent a “carry” product for the quarters to come, thanks to its limited sensitivity to higher rates and more stable credit fundamentals.

The challenges associated with integrating ESG criteria

In our view, there are two big challenges when it comes to integrating ESG criteria into a subordinated debt fund. First, having access to sufficient and reliable information, especially for non-listed or smaller institutions. We sold our exposures on one Swiss private bank and a French mutual insurance company, due to insufficient disclosure and overall lack of transparency. Thankfully, disclosure has been improving significantly these last two years, and we expect this issue to disappear over time. Secondly, how to deal with controversies? Assessing both financial and ESG impacts has to be done hand-in-hand with ESG analysts. We have, for example, sold our exposures to a Nordic bank, due to the materiality of a money-laundering scandal.

Inflation risk and credit markets

High Beta credit markets, namely segments which are not too sensitive to higher rates, can tackle potentially higher inflation. Higher inflation, which should translate into higher rates, can bring back some investors which left credit markets due to insufficient yields. Yet, what matters most is not the absolute level of rates, but rather the pace at which fixed income investors adjust to them. In other words, volatility on rates is the true danger here in my opinion, rather than the return of inflation, which shouldn’t have an immediate strong impact on the European monetary policy.

Consolidation of the European Banking sector

The consolidation of the European banking sector is a positive tidal wave for subordinated bondholders. European politicians and regulators have gotten rid of their “Too Big To Fail” mantra, which had an awful effect on the perception of systemic risk for the whole sector. With lower-for-much-longer rates and hampered profitability prospects, banks have no choice but to get together in order to reduce their costs, while continuing to strengthen their balance sheets in order to satisfy ever harsher capital requirements. We are left with fewer issuers, but whose credit quality tends to be more solid on average and whose subordinated bonds get bigger and which are more frequently traded and easy to access.

Positive outlook on Spanish banking sector

We have been holding for quite some time a positive view on the Spanish corporate sector and especially on its banking sector, which has experienced a very challenging, but successful, restructuring process. There were more than 60 credit institutions back in 2009, while there are less than 15 nowadays, whose fundamentals are much more resilient than before. Some institutions may – again – merge one with another in the future, but we feel like we’re at the end of the road, consolidation-wise. We continue to see good opportunities on second tier players and regional banks, which currently benefit from sound fundamentals and attractive yields.

Subordinated Debt and Coco’s strategies are available only to professional investors as defined below. Execution services shall only be provided to professional investors. Non-professional clients (negative target market) are excluded.

Professional investors have the following characteristics:

• sound knowledge of financial products and transactions:
• experience in the financial industry.

Subordinated Debt and Coco’s strategies are not accessible for non-professional investors, unless they obtain professional investment advice AND investment in the strategy is solely for the purpose of diversification or a mandate has been signed. 

Risks associated with an investment in subordinated debt instruments: Risk of capital loss, interest rate risk, credit risk, risk arising from techniques such as derivatives, counterparty risk, risk associated with holding convertible bonds, risk related to contingent convertibles, equity market risk, potential risk of a conflict of interests, legal risk)