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Discounted Perpetual FRNs – Attractive Risk-Reward

Highly attractive features – especially as a diversifier

  • Legacy capital securities issued by banks and insurers under previous regulatory regimes, close to $15bn equivalent outstanding
  • Attractive asset class that has been under pressure in 2018 due to risk-off tone and increased re-pricing to perpetuity
  • Interesting asymmetric upside/downside risk due to low cash prices, interest rate protection, gearing to spreads, previous management action and regulatory changes
  • Beyond significant price upside, instruments mitigate interest rate risk in a portfolio context with floating coupons structures

 

Discount Perpetual FRNs – The Basics

Instrument structure

Main features

  • Perpetual subordinated debt instruments issued under previous regulatory regimes – DISCOs mostly issued by banks and mainly USD-denominated, CMS/CMTs by both banks and insurers and mainly EUR-denominated
  • Floating coupons with low margins (spread paid typically <50bps over the reference rate) – DISCOs indexed to Libor, CMS/CMTs to 10y rates (Swaps or Government Bonds)
  • Periodically callable at par (annually or more frequently)
  • Instruments trading at very low cash prices (average price around 70%) due to low margins and floating coupon structure is attractive to benefit from higher interest rates

 

Discount Perpetual FRNs – The Basics

Instrument structure

 

Discount Perpetual FRNs – Drivers of Performance

Geared to higher rates and tighter spreads

Interest Rates

  • Benefit from higher rates as coupons are reset periodically and mitigate interest rate risk compared to fixed-rate instruments
  • USD DISCO coupons have increased to c3% from <1% in 2015

Spreads

  • Benefit from tighter spreads as the margins paid are more attractive
  • Tighter spreads increase the probability of instruments being taken out and refinanced with fully eligible instruments (extension risk re-pricing)

 

Discount Perpetual FRNs – Drivers of Performance

Geared to higher rates and tighter spreads

Management Action

  • Inefficient legacy capital securities
  • More than 30% of instruments have been subject to LME
  • Limits downside risk as it sets a floor price where issuers are willing to take out bonds

Attractive bonds benefitting from higher rates, tighter credit spreads and play the theme of capital optimization

 

Discount Perpetual FRNs – Regulatory Framework

Catalyst for future management action?

Current regulatory framework

  • 50% of instruments are fully ineligible as capital post grandfathering period (Jan-22 and Jan-26 for banks and insurers respectively)
  • Usually only eligible as weaker forms of capital if any eligibility under current regulatory regime
  • As we progress through the grandfathering period this increases the chance of calls or LME
  • Aegon’s management team commented that they will gradually refinance legacy bonds until Jan-2026 with fully eligible Tier 2s or RT1s. Aegon € CMTs are currently trading at 72% which is a >5% yield to Jan-2026

 

Discount Perpetual FRNs – Regulatory Framework

Catalyst for future management action?

Upcoming changes in regulation

  • CRR2 will be implemented in 2020 which will further disqualify instruments (mainly SPV-issued and foreign law bonds) hence increasing the regulatory inefficiency of instruments
  • Regulatory pressure for issuers to clean their capital structure is material
  • The Bank of England commented that all instruments should be issued of the resolution entity (HoldCo) and all OpCo issued securities potentially problematic in a resolution scenario, a positive for OpCo issued DISCOs from UK banks

The current regulatory framework and upcoming changes in banking regulation is likely to be a catalyst for issuers to clean up their capital structures – providing upside for bondholders

 

Discount Perpetual FRNs – Asymmetric risk-reward

Upside potential and hedge against interest rate risk

Current downside limited by previous management action and low cash prices

  • Average low cash price around 70%
  • Previous tenders, exchanges and purchases “floors” downside
  • Heavily trading to perpetuity which is unwarranted in our view

Upside potential from capital gains…

  • Changes in regulation lead to instruments being increasingly inefficient from a regulatory capital perspective
  • Upside from potential calls (periodically callable) and potential LME

 

Discount Perpetual FRNs – Asymmetric risk-reward

Upside potential and hedge against interest rate risk

…and attractive to mitigate interest rate risk in a portfolio context

  • Floating rates coupon structure provide upside to higher interest rates
  • Mitigate interest rate risk in a portfolio compared to traditional fixed-rate structures

Overall, we view Discount Perpetual FRNs as a highly attractive asset class within subordinated financials debt

  • Asymmetric upside/downside risk provides significant upside from price appreciation and “floored” downside
  • Floating coupon is highly attractive in a portfolio context to mitigate interest rate risk
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