There have always been some wacky bonds out there, but until now bonds have always had one thing in common: they rank above equity in the capital structure. What do I mean by this? When any company gets into financial difficulties there is a strict order in which creditors/investors must be repaid. In very simple terms it goes like this:
|Source: Brewin Dolphin|
Why is this important? Banks are required by the regulators to maintain a certain amount of capital in their structures in order to absorb losses. Historically, many hybrid bonds have been considered as capital for regulatory purposes because the bank has the ability to, for example, stop paying interest or convert the bonds into common equity if they get into difficulty, although in practice most issuers have not chosen to impose losses on bondholders.
Basel III has changed all this, however, by redefining capital as predominantly consisting of common equity and retained earnings. This has had the effect of making much of what was previously considered by the regulators as capital redundant, which in turn has led to many banks paying back these instruments early and has resulted in a rally in bank debt this year. Over the 11 months to the end of November 2012, sterling financial bonds were up 22.1% (total return).
But if banks are retiring their old bonds, and regulators are getting stricter about what they count as capital, this raises the question: when is a bond not a bond?