Credit risk is one of the most fundamental concepts in fixed income investing. It refers to the possibility that a borrower — whether a company, financial institution, or government — will fail to make timely payments of interest or principal on its debt. Investors experienced this with Digicel and the Government of Barbados for example. To compensate for this risk, Investors in bonds are compensated for this risk through the yield they earn. The difference between the yield earned and a risk-free benchmark (such as the US or German Government) is an indicator of the credit risk of a bond.
Not all bonds carry the same level of credit risk, even when issued by the same company. This is because a company’s debt is typically issued at different levels of its capital structure. The capital structure ranks obligations in order of payment priority, from senior secured debt at the top, down to subordinated debt, hybrid instruments like contingent convertible bonds (“CoCos”), and finally to equity holders at the bottom. When a company gets into financial trouble, the most senior creditors have the first claim on assets, while junior creditors and shareholders absorb losses first.
Enhancing Returns by Moving Down the Capital Structure
For investors seeking additional yield beyond what senior bonds offer, one strategy is to move further down the capital structure by investing in subordinated debt or hybrid instruments. Subordinated bonds rank below senior debt but above equity, meaning they are more exposed to losses if the issuer fails. To compensate investors for this increased credit risk, subordinated bonds offer higher yields.
A classic example comes from the banking sector, where subordinated bonds and contingent convertible bonds are common. Contingent convertibles, or CoCos, are hybrid securities that automatically convert into equity or are written down if the bank’s capital falls below a predefined threshold. For example, an investment grade rated European bank like HSBC might issue senior bonds at a yield of 4%, subordinated bonds at 6%, and CoCos at 8%. By moving down the capital structure, investors can pick up meaningful incremental returns while maintaining exposure to high-quality credit. Nevertheless, the investor also takes on more complexity.
Benefits Versus High-Yield Junk Bonds
An important question is why an investor would choose subordinated or hybrid debt from a high-quality issuer rather than investing in more senior, “plain vanilla” junk bonds from lower-rated companies. After all, junk bonds typically offer high yields too.
There are several key benefits:
- Better Underlying Credit Quality: Subordinated or hybrid bonds from strong investment-grade issuers are backed by fundamentally sound businesses. Even though these instruments rank lower in the capital structure, the probability of default is typically lower compared to an unsecured junk bond from a speculative-grade company.
- Stronger Recovery Prospects: In the event of default, subordinated debt from a quality issuer often has better recovery prospects than junk bonds. This is because the overall financial position of a high-grade borrower is stronger, and the loss absorption layers (senior debt, collateral) are usually more robust.
- Diversification of Risk: CoCos and subordinated bonds often behave differently than high-yield bonds during market stress. For example, CoCos are sensitive to regulatory capital requirements, while junk bonds are more exposed to business cycle risks. This provides a diversification benefit for a credit portfolio.
- Regulatory and Structural Support: Many subordinated and hybrid instruments from banks are designed to meet regulatory capital requirements, which can provide an additional buffer against losses. In contrast, unsecured junk bonds often lack such structural protections.
Final Considerations
While moving down the capital structure offers the potential for enhanced returns, it’s not without risks. Subordinated bonds can be more volatile, particularly in times of stress, and hybrid instruments like CoCos can carry complex features such as triggers for conversion, coupon deferral, or calls by the issuer. Investors need to fully understand these features before allocating capital.
Compared to outright junk bonds, however, subordinated or contingent convertible bonds from strong issuers offer a compelling way to capture higher yields while maintaining exposure to fundamentally stronger credits. For sophisticated investors, they can be a valuable tool to boost portfolio income while managing risk.
Marian Ross-Ammar is Vice President, Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm
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