Flavio Carpenzano, Francisco Sebastian
Faced with low yielding government bonds, many insurance companies have been increasing their exposure to corporate bonds. Within this sector, investment grade and high yield strategies are well known, but capital securities, the universe comprising junior debt and hybrid instruments issued by financial institutions, are less familiar.
In the following Q&A, we explain the role that capital securities can play in insurers' portfolios and how an allocation may serve as a substitute for equities, with potentially higher income and more efficient regulatory treatment under Solvency II.
Q: Why should insurers consider investing in capital securities?
Insurers increasingly use a range of assets to minimize the impact of a low yield environment. These include high quality investment grade credit, as well as high yield and emerging markets bonds. While there are strong reasons to invest in all of them, we think a separate allocation to financials, particularly the subordinated part of the capital structure, can be an attractive alternative.
Financial issuers are well known to insurers, who often invest in bonds or stocks issued by banks. In some instances, insurers’ portfolios include a barbell position, combining a bank’s senior secured and unsecured bonds with its equity. Adding an investment in the intermediate parts of the capital structure, including Tier 2 debt or contingent convertible or CoCo debt (including Additional Tier 1 or AT1 bonds), can be an important complement to this (see box).
Specifically, investing in subordinated and CoCo/AT1 bonds can:
The extent of these opportunities ‒ as well as the growing complexity of regulation and capital structures ‒ makes a strong case for considering financials as a separate asset class, rather than aggregating them with other corporate credit and equity investments.
Importantly, from a top-down perspective, we also think the bank sector overall is likely to perform well.
Q: Can you provide more detail on PIMCO’s outlook for the global banking sector?
Despite volatility in financials in 2016, the outlook for the banking sector globally remains strong. In the U.S., balance sheets are very robust, with capital levels for banks nearly doubling since 2007. Asset quality is also healthy with delinquencies normalizing.
In Europe, banks have raised more than €800 billion of capital since the financial crisis, and core capital ratios are now comfortably above 10%. Even in Italy, which has lagged its peers in addressing asset quality issues, the government and banks are beginning to take positive steps, including approving €20 billion in public funds to stabilize the most fragile institutions.
Banks’ profitability is also poised to improve as litigation risk recedes following major settlements. To date, the new U.S. administration has also been positive for bank equities as the market has priced in higher interest rates and a steeper yield curve, which are positive for earnings. In addition, the left tail risks for European banks the market had feared in the first quarter last year ‒ namely deflation risk and more negative interest rates in Europe ‒ have been curtailed. As a result, concerns on European bank profitability have also receded.
In the UK after the Brexit vote, potentially lower expected growth, low interest rates and rising political uncertainty could all weigh on profitability. However, the impact
on balance sheets is expected to be limited as capital levels remain high and banks' exposure to UK commercial real estate, which is likely to be the sector most affected by Brexit, has significantly declined (now 2%‒8% of each bank’s loan portfolio versus up to 20% before the financial crisis).
Q: What is the regulatory treatment of subordinated debt under Solvency II?
Solvency II is intended to be a risk- sensitive approach, under which insurers hold higher capital for investments with higher risk. However, the regulation does not determine whether subordinated instruments are risky or safe; this is instead determined by an analysis of the securities’ structural features.
As subordinated instruments stand between senior unsecured and common stock in the capital structure, the first step in determining the exact regulatory treatment is to clarify whether the securities fall under the equity or bond categories. The implication is non-negligible, as insurers need to set aside more capital to invest in equities.
For capital securities specifically:
Assuming that capital securities qualify as bonds, the next step in determining regulatory treatment is calculating the capital requirement. As bonds, the securities are subject to interest rate, spread and concentration modules. Insurers have extensive experience in managing interest rate and concentration risks, by offsetting interest rate exposures and increasing issuer granularity, respectively. Hence, the primary regulatory capital charge on the securities arises from the spread module. This is a function of duration and rating of each security in the portfolio, as Figure 2 shows.
Q: How have changes in regulation created opportunities for investors?
The global financial credit sector is very large, comprising $3.6 trillion of outstanding debt as of 31 January 2017. Around 75% of the market consists of senior debt, with the remaining 25% composed of subordinated securities, including Tier 2 bonds, U.S. bank preferred stock and the new hybrid instruments issued outside the U.S., known as CoCos/AT1s. The subordinated part of this market is growing fast: As of 31 January 2017, the total universe of CoCo/AT1 instruments was around $173 billion and is expected to grow to over $300 billion by 2019.
Regulatory changes have helped spur this growth, and we expect this to continue with the gradual implementation of Basel III acting as a catalyst for subordinated issuance, particularly from emerging market banks. Any future regulation on financial institutions should also underpin this trend.
An unintended consequence of these changes is that the complexity of banks’ capital structures and the range of instruments issued by financial institutions have increased. This is partially due to the EU Bank Recovery and Resolution Directive (BRRD), which became effective in January 2016, and provides authorities with increased intervention powers to deal with failing banks. Under the new resolution regime (so-called “bail-in”), once a bank has "failed", both shareholders and unsecured creditors (in the hierarchy of the capital structure) must absorb losses before any potential government intervention.
This change significantly modifies the treatment of senior-debt holders, who now face larger potential losses under bank insolvency scenarios. However, we do not think this is entirely reflected in valuations: Yields remain very low for senior debt issued by European banks (typically 1% or less), compared to yield of 6%‒8% for CoCos/AT1s. We think these are attractive subordinated premia given strong fundamentals.
Another layer of complexity stems from the differences in resolution frameworks and creditor hierarchy across jurisdictions (see Figure 3). This has again increased the complexity of investing in banks, but it has also created opportunities for active managers in the senior part of the capital structure, as “bail-in” risks can impair senior bonds when issuer fundamentals significantly deteriorate.
Q: What is PIMCO’s approach to investing in capital securities?
Our approach combines macroeconomic analysis with a fundamental, bottom-up style of picking individual securities. For capital securities, top-down analysis is used primarily to assess macro risks, such as sovereign risk, and to formulate the stress-test assumptions we use for global banks. PIMCO’s bottom-up bond selection process is based on thorough fundamental analysis by our credit research group, with more than 50 seasoned analysts, 11 focused exclusively on financials; they work with six traders dedicated to securities issued by financial firms.
In financials, particular emphasis is placed on analyzing the structure of each issue. The team’s efforts are supported by quantitative financial engineers who assist in valuing the embedded optionality in many of the securities.
After screening securities through our top-down, bottom-up and valuation measures, we focus on those with the best risk-adjusted yields across the capital structure and in any currency available. Currency risk is typically hedged, so the decision to invest is based on valuations.
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