Tuesday 19 June 2018 by FIIG Securities skippers Trade opportunities

Reduce risk in your portfolio Part 3 – Go over rather than under

One of our recurring themes is to reduce risk in your portfolio. This week we make some suggestions for secured over unsecured and senior bonds over subordinated. The note lists eight secured bonds including the specific security for each one

If you are an existing client, you’ll appreciate how important it is to know where your investment sits in the capital structure. The higher up you are the lower the risk and thus the lower your expected return within an individual company structure.

The capital structure helps explain relative risk and reward. In any one company, secured debt or bonds will have preference for repayment in a wind-up or liquidation over unsecured debt or bonds. One important thing to understand is if there is any bank debt in the structure, and whether the bonds sit higher, rank equally or sit lower in the capital structure.

In the simplified bank capital structure diagram below, clearly senior secured bonds rank higher than unsecured bonds, while subordinated bonds rank lower again.

Simplified bank capital structure – priority of payments in liquidation

Secured over unsecured

Having defined security supporting your investment gives additional comfort in a wind-up or liquidation.

Many bonds are secured, and some have first or second ranking over the same security, so priority in relation to specific security can be important. Some security may be independently valued. If so, recently dated valuations from well know valuation companies may carry greater comfort.

In the case of high yield entities, some may have to offer security to get consent for the transaction, while others use security to reduce the cost to borrow.

A company that has an investment grade rating will not necessarily offer security for its debt/bond. Sometimes the market seems to forget that high rated companies can also offer secured bonds, which is unusual, so these companies can be good targets.

See the table below for a sample of secured bonds.

Sample senior secured bonds
To see the table in full size, right click on the table and select 'Open image in new tab'

To illustrate the effect of secured vs unsecured positions we can use JC Penney as an example. JC Penney’s Chairman and CEO Marvin Ellison resigned in May 2018 to pursue another opportunity. S&P noted that Mr Ellison has been the instrumental to the company’s turnaround plan since late 2014 and the announcement increases risk around the company’s ability to execute its strategy and uncertainty around the path forward under new management. 

Ellison’s departure saw the senior secured and the second lien bond prices fall as shown in the graph below. The second lien bonds rank behind other secured investments and are higher risk. Thus the more dramatic price drop on announcement of the CEO’s departure.

The JC Penney bonds demonstrate the reason Mark Bayley suggested in his Macro credit outlook: Mid-year update to favour secured investments where available over more junior instruments.

Source: FIIG Securities

Senior over subordinated

Few Mum and Dad investors understand the capital structure diagram and the changing risk, various terms and conditions of the levels. A good example is bank hybrids compared to term deposits or any of the other investment levels. Hybrids are structurally low and with complexities that include:

  • Call options that are reliant on certain APRA requirement and approvals, that if not obtained mean the hybrid is perpetual and has no maturity date
  • Income distributions can be missed and never made up. Mitigating this risk is a dividend stopper clause
  • A minimum capital requirement that if breached triggers conversion to shares (downside risk is the same as that for shareholders)
  • A non viability clause, at APRA’s discretion, where the hybrids convert to shares

In contrast, subordinated bonds have a definitive maturity date, cannot forego income payments and do not have a capital trigger clause. They do however also contain a non viability clause.

So, we prefer the higher level subordinated financial institution bonds to hybrids. Three options include:

  • IAG with a first call June 2024, floating rate with a yield to worst of 4.17%pa available to wholesale investors only
  • Challenger with a first call November 2022, floating rate with a yield to worst of 3.96%pa available to wholesale investors only
  • ANZ with a first call May 2021, floating rate with a yield to worst of 3.21%pa available to retail and wholesale investors

For more information, please call your local relationship manager.