Tuesday, 18 December 2012

When is a bond not a bond?

As 2012 draws to a close, I thought it might be nice to reflect on some of the key events that shaped the markets this year. So what should I choose? I could talk about Draghi’s “Whatever it takes” speech, which settled the markets nicely, ready for a rally in risk assets in the second half of the year. Or perhaps I should discuss the impact that the US elections had, and the implications of Obama’s election success going forward. These issues have already been dissected and mulled over though, and I know that in 10 years' time when I look back on 2012 it will not be these things that I will remember. No, because I have spent my entire career working in fixed income and for me 2012 will forever be known as “the year that bonds changed”.

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 as discussed in Banks, Bonds and Basel III. 2012 changed all this, however, when Barclays issued a contingent capital note, whose very existence depended on the financial health of the issuing company. 

There is a strict order of payments for all companies, and banks in particular often play on this by issuing bonds from different parts of the capital structure. The difference with these new bonds is that the payment of both interest and capital was contingent on the bank maintaining its capital ratio above 7%. If the capital of the bank was to fall below this pre-specified level, not only would the bonds stop paying their coupon, but their entire value would be wiped out. Not only this, but it would be wiped out (and this is the crucial point) BEFORE the equity of the bank. In other words, this bond ranks below equity in the capital structure. Which raises the question: is it really a bond?

When rumours of this instrument hit the market, speculation was rife, and talk centred mainly around one question: what price do you put on an instrument which has higher risk than equity, but a limit to capital gains? I have discussed this question with many other investors, brokers, salesmen and eminent fund managers and for once we were all in total agreement – the return should be a handsome one! So when it was announced that the yield would be 7.625% we were more than a little surprised and dire predictions were made of embarrassment on Barclays’ part in the event they failed to sell all of the $3 billion issue. The laugh was on us though, because they did!

In such a low-yield world, maybe some investors are willing to take on more risk than others in order to get a decent income stream. Rumour has it that the issue was very popular in Asia, which makes a little more sense when you think how low yields are there.

So if 2012 was the year when bonds changed, should we expect more of the same next year? It must certainly be tempting for other banks who are trying to improve their capital ratios to issue this kind of debt. I still don’t think I will be buying it at 7.625% though – if I wanted to be an equity investor I would buy equities!

Victoria Hasler
Fund Analyst

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