Riskiest Bank Debt Pays Off as Safety Net Erected Under Lenders

  • Contingent capital securities returned 8 percent this year
  • Bank bond risk falls below investment-grade corporate risk

Regulators’ efforts to make banks safer are paying off for investors who prefer to live a little dangerously.

Buyers of bank debt that would be written off first in a crisis have earned an average of 8.2 percent this year, according to Bank of America Merrill Lynch’s contingent-capital index. The notes were the best-performing credit assets globally, according to Royal Bank of Scotland Group Plc.

Tighter rules forcing banks to hold more capital and curb speculative activities have boosted confidence in even the riskiest of lenders’ bonds, known as additional Tier 1 securities. At the same time, quantitative easing in Europe has suppressed yields, luring investors to higher-yielding debt.

“Regulators have crafted the perfect environment for bank credit investors,” said Lloyd Harris, a London-based portfolio manager at Old Mutual Global Investors, which manages 22 billion pounds ($33 billion) of assets. “Money and lending is being kept on a tight leash.”

AT1s are gaining as banks strengthen their balance sheets before new capital rules start in 2019. Lenders are selling assets and raising funds, reducing the risk they’ll fail. Standard Chartered Plc, for example, increased its equity cushion by raising about $5.1 billion.

Lenders worldwide are also curtailing riskier businesses as the new rules, introduced in response to the global financial crisis, make them less lucrative. Royal Bank of Scotland Group Plc sold U.S. consumer bank Citizens Financial Group Inc. and Morgan Stanley is among banks cutting fixed-income divisions.

Capital Rules

The popularity of AT1 notes, which convert into equity or are written off if a lender’s losses mount, has also climbed amid a slowdown in new issuance.

“The direction of travel is firmly toward better capitalized banks,” said Jakub Lichwa, a credit analyst at Daiwa Capital Markets in London.

The cost of insuring debt sold by financial companies in Europe dropped below that for investment-grade companies, according to credit-derivatives indexes. The relationship was mostly reversed since the financial crisis.

Total returns on AT1 securities include coupon payments that are typically about 6 percent to 8 percent a year, helping to cushion against losses. The rewards investors are reaping from the securities compare with moderate returns or losses on other debt.

While senior bank bonds in Europe and the U.S. have generated small profits this year, investment-grade corporate bonds in euros lost an average of 0.4 percent, the first loss since 2008, and similarly rated U.S. bonds declined. Lower liquidity is curbing the appeal of bonds that were once seen as havens, according to JPMorgan Chase & Co.

High-yield bonds in the U.S. lost an average 4.7 percent, the first drop in seven years, according to Bank of America Merrill Lynch, as a slump in oil prices makes it difficult for energy companies to service their debt.

“Bonds can be bailed in if a bank runs into trouble, but the likelihood of that has really diminished,” Harris said.

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