Potential opportunities in legacy debt

Bonds can be held to maturity or traded during the bond’s lifetime as analytical judgments are made about the value of the bond.

Sometimes, the holding period is not fully in the hands of the investor as the bond issuer might redeem the bond ahead of its maturity date. In the absence of a contractually defined call option, whereby the bond would be redeemed either at a set date or upon the occurrence of certain events (eg, regulatory or tax events), an issuer can offer to buy back bonds at a specified price on a specified date (known as a debt tender offer).

For investors, a key challenge with bank subordinated bonds – which can be perpetual instruments with contractually-defined call dates – is to estimate when they will receive the principal back. Investors will seek to profit from a discrepancy in the extension risk (the risk of the bond not being called at the expected date) reflected in the market price and their own view of the effective maturity of the bond. Investors can do so by identifying incentives for an issuer to want to redeem their bonds, in particular considerations around the regulatory treatment of the bonds.

Capital treatment

In response to the earlier Global Financial Crisis, the European Union’s (EU’s) Capital Requirements Regulation (CRR) of 2013, brought in more stringent rules on regulatory capital for European banks. This had implications for some forms of debt capital, notably legacy bonds. These are bonds issued by banks under previous regulatory regimes (ie, prior to CRR), under which they were often treated as Tier 1 capital for regulatory purposes. As a reminder, European bank capital is classified in tiers of loss absorption, the lowest tiers being the ones first in line to absorb losses and the ones with the most regulatory credit.

These legacy bonds have retained eligibility as Tier 1 capital under grandfathering provisions, but this is set to be largely phased out by January 2022. Depending on their individual contractual features, post-grandfathering, these instruments will be treated either as Tier 2 capital, non-preferred senior or ordinary senior funding, hence reducing their capital efficiency.

Another issue around these bonds has been whether they would disrupt the creditor hierarchy in a resolution. This risk, termed “infection risk”, refers to situations whereby the legacy bonds lose regulatory value and “infect” pari passu bonds, which would have to be disqualified as well under the “no creditor worse off” principle enshrined within the EU’s Bank Recovery and Resolution Directive (BRRD).

This would be particularly problematic for Additional Tier 1 securities (AT1) which rank pari passu with most legacy securities and are an important component of banks’ regulatory capital stacks. The European Banking Authority (EBA) provided some guidance around this issue in its opinion on the prudential treatment of legacy instruments published last October.¹ The EBA paper confirmed the infection risk and guided that their two preferred options for treating infection risk were:

1. to call, redeem, repurchase or buyback the instrument;
2. to amend the terms and conditions of the bonds.

The latter option would likely require the bond issuer asking the bondholders if they would agree to altering the terms of the security (a process known as consent solicitation), which bondholders might be reluctant to accept given their preference for a call or tender offer.

Pressure to redeem

Our read of the EBA paper is that regulatory pressure is building for banks to redeem these legacy securities before the end of this year, when the transitional arrangements expire. Earlier-than-expected calls or tender offers at a price over market levels could potentially generate attractive returns for holders of these bonds.

We have taken a selective approach to picking the bonds with the most upside potential in our view, focusing on bonds whose terms and conditions include clauses that make them more likely to lose regulatory capital eligibility. Examples of such bonds include bonds issued out of special purpose vehicles, bonds issued under foreign law without contractual recognition of bail-in, bonds featuring dividend pusher / stoppers or incentives to redeem, and retail-focused bonds. A reference to Libor with weak fallback language could be a further reason for issuers to redeem the bonds as the benchmark rate is phased out. We believe that focusing on bonds with such features as well as taking into account our view on issuers’ inclination to pursue bondholder-friendly actions make investments in these bonds less susceptible to disappointing outcomes. Many legacy bonds were also trading at a discount to par, which we see as another supportive factor in our investment thesis.

Possible hurdles

The main risk to our stance is being too optimistic on the date at which the instrument loses regulatory value and seeing the bond being extended beyond what is priced in. This could happen if a statutory solution simplifying the creditor hierarchy in a resolution is adopted in the domicile country of an issuer, but we understand time is limited for countries to go down that route. Some banks might also qualify for the “last resort” option cited in the EBA paper, which is to keep the instrument in the balance sheet as a non-regulatory instrument.

We have already seen a number of these legacy bonds being called in the past months, with some bank management teams confirming they have read the EBA paper in the same way as we have. There is also a positive correlation effect in this thematic trade, with the legacy space as a whole enjoying some degree of tailwind when a legacy security is redeemed, since with no new supply of this type of debt it creates a technical scarcity premium.