Junior debt issued by banks is normally one of the riskiest types of fixed-income in the US and Europe. It’s typically not backed by collateral and in the event of a crisis it only gets paid back after other bonds.
But in a world of soaring inflation and interest rates, it has a feature that suddenly makes it safer than just about the very safest of corporate bonds: the debt is usually repaid after a few years.
That gives it, in the parlance of Wall Street, short duration, a sure-fire way to avoid the sorts of brutal losses that investors in longer-term bonds are suffering as that surge in rates erodes the value of the future income they’ll receive. (No one wants an old bond paying, say, 3% when all the new bonds are paying 6%.)
Preferred securities issued predominantly by US banks, which are junior to all types of debt, have returned 5.2% so far this year while European banks’ own flavor of deeply junior debt, known as contingent convertibles, is up 2.8%, according to ICE BofA indexes. A broad index of global investment-grade bonds, meanwhile, has almost erased all its gains this year. The trend was much the same last year, with junior debt posting smaller losses than investment-grade.
One crucial factor in the outperformance is that the spike in interest rates hasn’t produced much of an economic slowdown yet and, as a result, banks’ balance sheets remain strong. The junior debt, given its weak credit protections, is hit hardest when banks’ finances start to deteriorate.
“The selloff has been very much an interest-rate event,” said Mark Lieb, chief executive of Spectrum Asset Management Inc. “This is not a credit issue.”
Lieb, a veteran evangelist for junior bonds that combine debt and equity features, was in Europe, pitching clients on the securities.
So too was Bill Scapell, head of fixed income at Cohen & Steers Inc. “Over a long period, total return is largely derived from the high income rate. You can be earning an additional 200 basis points in income over three to five years,” in preferreds compared with securities that are normally considered safer, he said.
Investors worried about buying corporate bonds with longer duration could, of course, just purchase senior bonds with shorter maturities. The problem, though, is that those bonds typically offer yields that are a lot lower than the rates paid by junior debt. So in a selloff triggered by a jump in broader market rates, their coupons are often not high enough to offset the losses suffered on the price of the security.
Corporate bonds maturing within five years have lost about 2 percentage points of their face value since the latest slump began in early February, based on an ICE BofA index. The interest they’ve accrued during that period has covered only a fraction of the decline.
Risks Abound
Holders of junior bank notes need to stomach risks that the senior-debt crowd doesn’t worry much about. Borrowers that are sinking into trouble can skip coupon payments; the exact repayment timeline of the notes can also be unclear.
The risk of major bank failures, though, is lower now than it has been historically, thanks to new rules that forced lenders to strengthen their balance sheets after the global financial crisis. The current climate of rising interest rates is also beneficial to banks’ net interest margins.
“Issuers’ balance sheets are in great shape,” Lieb said.
The contingent convertibles — also known as additional tier 1 bonds — issued by European banks this year feature high on the list of best-performing notes issued in the region in 2023, based on data compiled by Bloomberg. The 11 additional tier 1 bonds issued have seen average tightening of more than 50 basis points compared with about 6 basis points for all other types of notes, the data show.
Some analysts are also getting more bullish about junior debt. Barclays Plc strategists Soren Willemann and Chris Lau last week cut their expectations for spreads of dollar and euro-denominated subordinated debt over government bonds, and boosted their forecast for excess returns for dollar issues. They expect banks and non-financial corporates’ hybrid notes to benefit as the euro-area economy avoids a recession.
And Bank of America Corp. strategists have their eye on the chunky premiums in risky debt — which still heavily outweigh that of senior bonds — amid persistent inflation and uncertainty over central bank policy.
“Hide from the rates shock by dipping-down into higher-beta credit,” Bank of America Corp. strategists Barnaby Martin and Ioannis Angelakis wrote in a note to clients on Friday. “2022 showed that when rates are on the ascent, spread cushions across the corporate bond market become invaluable.”
