Moving lower down the capital structure of higher rated corporate issuers is one way to add higher returns to well diversified portfolios. In this article we take a look at what is the capital structure and current opportunities.
This document has been prepared by FIIG Investment Strategy Group. Opinions expressed may differ from those of FIIG Credit Research.
Background
The current low rate environment has many investors scratching their heads regarding how to improve investment returns without taking on too much risk. Unfortunately, the positive correlation between risk and return means that it is difficult to achieve better returns without incremental risk.
There are two ways to take on incremental risk, either by increasing credit risk or by taking on interest rate risk. Within credit risk there are also typically two ways to add incremental risk to generate a higher return.
One is to invest in bonds issued by companies with lower and/or sub-investment grade credit ratings such as The Hunt Cos Inc. 6.25% 15 Feb 2026 senior unsecured bond; and the second is to invest in junior ranking securities issued by larger investment grade rated companies such as the Macquarie Bank 6.125% 08 Mar 2027c junior subordinated bond. Both The Hunt Cos and the Macquarie bonds carry similar ratings but sit at opposite ends of the issuer’s capital structure.
In this note we will take a closer look at the latter of the two options mentioned above.
Capital Structure
So, what exactly is the capital structure? The diagram below should be familiar to most of our readers. It describes the simplified capital structure for a typical bank (as it includes term deposits). A corporate issuer would be the same but without this particular rung in the ladder.
Source: FIIG Securities
A few of the main considerations when analysing the capital structure of a company include:
- Risk - ranging from senior secured debt as the least risky down to equities as the riskiest.
- Priority of payment in liquidation/administration - senior debt should be paid out first (with secured debt having first call on the specified security), then all subordinated debt, then all hybrid debt and if any funds remain, equity holders share the balance. Some lower ranking securities also have the ability to defer coupons, which are usually cumulative.
- Application of losses - with equities to bear the first loss and the security of senior debtholders’ investments only threatened once all other junior capital sources have been exhausted.
- Maturity/call features - securities ranked lower down the capital structure tend to have longer (or perpetual) maturity dates with optionality for the issuers to redeem (call) the security prior to maturity.
In accordance with risk, the expected long-term return increases as you move down the capital structure.
However, if as an investor you feel comfortable with the credit risk of a company then by that logic you should feel comfortable investing lower down the capital structure of that company as the likelihood of receiving all the coupons and capital back on a subordinated bond is very high. Conversely, if the credit quality of the issuer is not as strong then it makes sense to move higher up the capital structure when investing in the bonds issued by the company.
Current opportunities
Below is a list of some recent investment opportunities, which sit lower down the capital structure of the issuer that our clients have been considering. Please contact your Relationship Manager if you would like further information about the risks and mitigating factors associated with these securities.
