With 10-year government bonds returning somewhere between 3 and 4 per cent alongside a relatively flat yield curve, institutional investors are busy searching for additional return – a search that is particularly relevant to pension fund investors.

As well as facing lower investment returns, pension funds have to deal with longer life expectancy and a move towards stricter solvency requirements, which increasingly forces them to mark their pension liabilities to market. All of which negatively affects their funding status. This is prompting them to look at enhancing the returns from their portfolio, including their fixed income assets, through alternative strategies. The challenge, however, is to achieve this without compromising the portfolio’s credit standing.

One route to achieving enhanced fixed income returns is to move down the credit scale into BBB-rated bonds and further into high yield. This may entail a higher level of risk than most pensions schemes are comfortable with. A better use of pension schemes’ limited risk budget may be to invest an appropriate portion of the fixed income portfolio in capital securities. This alternative approach is fast gathering momentum with institutional investors and involves accepting an increased level of structural risk within highly rated financial institutions by taking advantage of the higher yields offered by capital securities.

Still off-radar as a discrete asset class to many investors, the global capital securities market now exceeds the equivalent of $500bn of issuance, with issuers including many of the world’s most highly rated financial institutions.

What are capital securities?

Capital securities, as the name suggests, form part of the capital of banks and other financial institutions. In order to protect bank depositors from the possibility of loss, banking regulators require banks to hold a minimum of 8 per cent of their assets (loans, mortgages) in the form of capital. The regulators are anxious to maintain confidence in the banking sector by ensuring that banks are adequately capitalised and therefore that depositors are protected. From the banking regulators’ standpoint, the best form of bank capital is equity (common or ordinary shares) as it is perpetual (in that it never needs to be repaid) and payment of dividends is not obligatory.

In this regard, the needs of investors and regulators are not aligned as, ironically, conventional fixed-income bonds, which are most popular with institutional investors, are the lowest regarded form of capital for the regulator given that they must always be paid back at redemption. Unpaid coupons will constitute a default. So if a bank faces a large loss or a liquidity crisis, equity is the best form of capital to absorb or cushion depositors from loss.

Capital securities issued by banks are often referred to as “subordinated” debt given that they rank behind depositors and senior debt in the event of a bank’s liquidation. Importantly, unlike senior debt, they can be used as part of the minimum capital a bank has to maintain from a regulatory point of view. There are three main levels of capital that can be used to cushion the bank in distress, normally referred to as tiers of capital.

These tiers, which all rank below senior debt in the capital structure, are (in descending order of quality):

• Lower tier two: Subordinated bonds where interest cannot be deferred and failure to repay principal constitutes a default. These bonds must have a final maturity date.
• Upper tier two
  Junior subordinated bonds, where interest may be deferred but is cumulative – they must be paid at a later date. These bonds are perpetual, but have a “call” date where issuers can redeem or “call” bonds, or there is a coupon increase or step-up.
• Tier one
  Ranks ahead of common stock in the capital structure but is subordinated to everything else. These bonds are perpetual with a call feature, and any deferred interest is non-cumulative. They are sometimes referred to as ‘preferred securities’ or “hybrids”.

Thorough research is clearly key when investing in these securities, as the structural features of capital securities vary significantly, and upper tier two and tier one securities – the most risky from an investor standpoint – are normally perpetual bonds. Nevertheless, the majority of perpetual securities have a call date at which time the securities normally change from paying interest on a fixed basis to a floating basis and there is often a step-up in the coupon. In most instances, issuers will call (redeem) the bonds at the call date, not only because an extra expense would be incurred due to the increase in coupon, but also because failure to do so or to meet interest payments would cause severe damage to the bank’s reputation, which might imply that it faced a shortage of capital or was in some kind of difficulty. In practice, coupon deferral or failure to call a bond would only arise in the event of serious capital depletion. In effect, it would mean a bank would have used up all its profits and retained earnings, and so its equity would have fallen to zero.

Of the 8 per cent of assets that a bank must have in bank capital, one half may be in lower tier two and upper tier two structures. The other half must be in tier one capital and at least half of this again (2 per cent of assets) must be equity, preference shares and retained earnings. The remaining 2 per cent may be in tier one bank capital securities, or preferred securities, sometimes also called hybrids. These tier one securities are treated favourably by banking regulators from a capital standpoint because they have some equity-like features, as described above.

This is a key point, because it gives an effective way for banks to raise capital without having to issue equity, which causes dilution and is therefore unpopular with equity holders. It is also cheaper and more tax-efficient for banks to raise capital in this way.

Performance and credit status

As an asset class, global capital securities have performed exceptionally well over the last four years, and this trend is broadly expected to continue. Since December 2001, when Lehman Brothers constructed its global capital securities index, the average annual euro-hedged return from the index has been 8.5 per cent, with an annualised volatility (standard deviation) of 4.5 per cent. This represents a 1.9 per cent uplift in annualised return over Lehman’s Euro Aggregate Index during the same period, for only a 1.5 per cent increase in volatility.

The majority of capital securities issued by banks are rated single-A by the major credit rating agencies. The banking sector in general is very closely regulated and benefits from a consistent level of profitability. It is also the case that there is a large degree of assumed government protection from any credit event in a given country owing to the major role that banks play in the health of an economy.

Governments are aware how important it is to maintain confidence in the banking system and bank collapses are rare events, especially those where there are depositors. It is also helpful to note that most banks have capital well in excess of the minimum 8 per cent level, that most are making healthy profits after paying dividends and tax, and that they are committed to maintaining their solid credit ratings.

Capital securities are likely to continue to benefit from investor appetite for yield supported by the strong credit fundamentals of banks and ongoing credit upgrades. They provide attractive incremental yield compared with industrials, with sound credit ratings, and minimal event risk. An increasing investor base, high liquidity and a relatively limited supply of paper should provide further support.

A growing universe

Increasingly, many non-bank regulated entities, such as insurance companies, are now issuing capital securities in order to gain cheaper access to funds that receive favourable capital treatment from regulators. Insurers also enjoy relatively high levels of regulatory protection as they are seen as another crucial component of national economies. Again, issuers are of good standing and default risk is low. Finally, a small but growing proportion of issuance is emanating from industrial and utility companies, which are issuing capital securities typically equivalent to tier one bank capital.

Given the individual nature of many of these securities, the importance of specialist research cannot be underestimated. A handful of investment managers have already developed the specialist skills and resources needed to provide investors with a route into capital securities, and in Germany in particular, institutions have caught on to the enhanced returns available from taking structural, rather than credit risk. As recognition of the asset class continues to grow, Nordic investors are likely to follow suit.