Most of my friends know what I do for a living, and I have had countless and endless discussions with them not only about my job by also about theirs over recent years.
However, with my 4-year old now at school, my social life is practically her social life over the week-end, and at this age, it is either at the park, the swings, or at birthday parties of her school friends. So over the past 18 months, I’ve got to know quite a few number of mummies and daddies. And inevitably, after speaking about our children’s life at school, conversations somehow always end up being about work.
This weekend my daughter was invited to a birthday party and I had a long conversation with an old acquaintance of mine. After spending the first fifteen minutes catching up on each other’s recent lives, we soon got down to the serious stuff.
After filling each other on each other’s jobs, Peter was enthusiastic in telling me that his marketing firm was growing at such a rapid pace that his partner at work and himself had just decided to invest some of the excess cash they had which was laying idle in a bank account.
Peter was not oblivious to happenings in the market; he was aware that since December 2015 markets had corrected sharply, the US Federal Reserve had hikes rates and that the global economy was in the doldrums following a series of negative data from China, Emerging Markets as well as a handful of developed economies. “Mark”, he told me, “Do you know what I just bought? Some UK Bank bonds of ABC Bank plc* and XYZ Bank plc*, what do you think?
After the sharp market correction prices became more attractive than they were 3 months ago so I decided to take the plunge and put some money to work in English banks (*bank names are not being divulged here, its besides the scope of the article). I mean, they are quite sold banks right, what could possibly go wrong?”
Without going into the merits of whether the investment was a sane investment or not, and whether this investment tied in with his (and his partner’s) risk tolerance, and whether I was comfortable with the underlying credit risks of those banks, I asked Peter “Pete, those banks are what are known as systemically important banks for the UK economy hence the notion by investors that nothing could possibly go wrong, but it is important to differentiate between different banks as they do not all have the same risk profiles, business models, streams of income and some are hence riskier than other. Even within the same bank, there are risky bonds and less risky bonds. What seniority are the bonds which you purchased? Where do they lie in the capital structure of the banks?”
“Huh? Seniority? Capital Structure? What are you on about Mark?”
I was a bit puzzled here because I was aware that Peter is the kind of guy who would want to have all the facts at hand before taking any decision, especially an investment related one.
On one end I wanted him to know that before investing, investors need to educate themselves at that it takes a steep learning to get to grasp some basic concepts of investing, whilst at the same time did not want to startle him at not knowing the answer – but tried my best to get my point across, and explain, as best I could the differing levels of a capital structure of a bank, and how, the lower one goes, the riskier an investment gets and naturally, the rate of return increases.
“Pete, banks can issue bonds at different levels of its capital structure, the list is as follows, from top to bottom: Covered Bonds (Senior Secured Debt), Senior unsecured debt, Subordinated Debt, Hybrids (Deeply Subordinated Debt such as Contingent Convertible bonds or Additional Tier 1 bonds).
Those bonds at the top of the capital structure have a lower risk assigned to them, and the risk increases the further down the capital structure you go. This explains why bonds issued by the same bank have different credit ratings. Furthermore, and this point also ties in to the issue of risk and credit rating, in the event of a default of a bank, the bonds at the higher end of the capital structure have priority of
payment. This means, that the deeply subordinated bonds would be the first to absorb losses in the event of the issuer, in this case a bank, failing to meet its financial obligations. The safer the investment, the more protection an investor gets in times of distress.
In addition, most Contingent Convertible bonds or Additional Tier 1 bonds (better known as CoCos) can be converted into bank equity if the bank’s financial ratios do not meet a specific set of criteria. Now I’m not quite sure whether this investment you’ve just made is suitable for you or not, it could pretty well be, but it is wrong to assume that companies and/or banks are infallible.”
This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.