Published in The Australian 21 April 2015
Property investors know and respect the most important words in property: “location, location, location”. In bond and fixed income markets, the equivalent of the magic word “location” is the term “capital structure”, which determines who gets paid out first in the event of a company wind-up
Just how important capital structure can be was displayed again with news on 20 April 2015 of the collapsed debenture company Provident Capital. Depending on where investors sat on the capital structure there was a range of outcomes. Some debenture holders will recover only 16 cents in the dollar. Whole banks — such as Bendigo Bank — which were higher up in the capital structure recovered 100 cents in the dollar.
The seniority, or rank in the company’s capital structure, is crucial in determining whether the return offered adequately compensates the investor for the risk involved. Every bank and company has its own capital structure and it is legally binding.
In the event of windup or liquidation, funds are paid to the most senior investor in the capital structure (senior secured debt) first and these investors must be repaid in full before any funds are paid to investors on the next level. In turn, each level must be repaid in full before funds are apportioned to the next level. The higher your investment sits in the capital structure, the lower the risk.
Diagram of capital structure explaining priority of payment. Source: FIIG Securities
Investments at the top of the structure have known interest and maturity dates. Companies that miss paying interest or principal face serious consequences.
Moving down through the rungs, terms and conditions change and there is less certainty. Interest can be deferred or not paid at all, while maturity dates can be extended or become perpetual where there is no obligation to return principal to the investor.
Investments lower in the structure do not offer the same certainty and are thus higher risk, and should offer higher returns to investors. For example, there is no obligation for companies to pay dividends to shareholders; they can be cut without any consequences for the company and there is no repayment date. Shareholders must sell shares to recoup capital. This uncertainty needs to be adequately rewarded with higher returns.
In liquidation, losses are applied from the lowest level up, making shares the “first loss” and highest risk investment in the capital structure. Each rung from the lowest up must be “wiped out” before the next rung up on the ladder takes any loss.
New Basel III regulations mean bank hybrids can convert to shares on breach of a capital trigger and bank subordinated debt and hybrids can be deemed “nonviable” by APRA and also converted to shares. These conditions increase the risk of the new style investments and need to be compensated through higher returns. In essence the regulations are to ensure the bank maintains sufficient capital for its operations and they protect investors sitting higher in the capital structure.