Subordinated bonds - what is it?

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

A feature of a modern developed economy is the presence of a large number of financial instruments. And within the framework of this article, we will consider what subordinated bonds are.

General information

In short, subordinated (secondary) bonds are a high-risk enrichment tool. Why does it attract investors? So what are subordinated bonds? In essence, this is a company loan that has a lower priority than other loans in the event of bankruptcy or liquidation of the company. In other words, their holders will be the last to claim a share in the company's assets if something happens to it.

Often subordinated bonds are also called “subordinated” or “junior”. It is clear that this state of affairs creates additional risks for their holders. And they should be compensated by increased profitability. By their nature, these bonds are quite a risky instrument. Therefore, the requirements for their issuer are lower. As a result, it is easier to ensure the issuance of securities. High yield andat the same time, a significant queue in case of payments makes their holders a kind of quasi-shareholders.

Who makes them?

This tool is used by business owners who need liquidity. But at the same time, they do not want to dilute their capital with an additional issue of another block of shares. As a rule, difficult situations with debts or disloyal market conditions prevent you from getting by with ordinary bonds. Also, in practice, the use of this tool is popular in the interaction of the parent and subsidiary companies.

Let's consider a small example. Let's say the subordinated bonds of the Savings Bank seem to be something fantastic. But they exist. And the use of this tool to support a company in which they own a significant part of the power and even have their own directors is a widespread practice. Although, in pursuit of yield, investors may purchase subordinated bonds of banks that are in a difficult position.

Small work example

Let's look at what constitutes a subordinated loan using the example of the relationship between the parent and subsidiary companies. So, the second issues bonds, which are subsequently fully redeemed by the first. This may be done for additional funding to increase liquidity, or when the subsidiary is not of interest to investors.

Otherwise, you can get by with bonds, which are cheaper. But their main purpose is to servelifelines for the liquidity of the organization in cases where no other tool can fully fulfill this role.

Who works in this market?

The most interesting subordinated loans/deposits are for banks, which account for a significant share of all bonds of this type. Why exactly? This is due to the nature of their work. It's all about the so-called credit lag. Let's consider a small example. The bank attracts a deposit from an individual. He immediately has money. He makes loans. But if an individual requires their funds, then certain problems may arise with their return. To avoid them, the instrument of financial leverage is used. It lies in the fact that the bank must always have a certain reserve of funds for unforeseen situations.

In order to receive it, the issue of subordinated bonds is organized. This is very convenient for organizations that are growing rapidly. They are usually issued for a period of five years. Although a specific period may not be indicated. Peculiarities of perpetual subordinated bonds are that they pay a certain dividend. Whereas the principal amount is not repaid. But, alas, these advantages of the tool coexist with limitations. So, in case of violation of existing standards, issues are written off. In other words, the owners are not so lucky to be at the end of the queue for assets, but they will generally lose their chances of getting at least something.

Security specifics

Now all these bonds are serviced in accordance with the Basel III standard. According to him, these securities are considered as second-tier capital. By the way, a particularly important point should be noted: in the case when the deposit insurance agency begins the bankruptcy prevention procedure and the bonds fall in price, they turn into ordinary shares. It is legally established that this threshold is 2% of the cost. Therefore, this is a last resort.

What is Basel III?

This is the standard of banking supervision. Issued by the Basel Committee, established in 1975. It includes representatives of the Central Banks of the countries with the ten largest GDP. It was created in order to develop rules, standards and methodologies that will prevent significant losses for institutional investors.

Three papers were issued in total. Each of them to some extent normalizes the level of reserve capital, while taking into account credit risks. The Russian Federation has ratified all three documents. Although, with certain amendments. And there are a number of reasons for this:

1. Lack of necessary personnel and funding for the full implementation of the system;
2. Lack of statistics on losses due to operational and credit risks;
3. A small number of national rating agencies;
4. Lack of uniform standards for defining default, credit losses and arrears;
5. Lack of impact researcheconomic and industry cycles on the level of risks and losses of banking institutions.

But if there are problems, why are they introduced? There are several reasons for this:

1. Improve the quality of risk management. Ultimately, the stability of the entire banking system is ensured, and the rights of depositors and creditors are protected.
2. Normalization of activities at the international level.

Why is there interest in this topic?

The situation with FC Otkritie is to blame. The fact is that this structure has created a significant heap of problems that can cost more than one trillion rubles. At first, there was a panic and the possibility of losing funds, but then the Central Bank of Russia decided not to impose a moratorium on payments to depositors of the structure, but assumed obligations to service the institution.

Although a certain wariness still remains. For example, subordinated bonds once traded at 20% of par. Of course, there was a lot of uncertainty about the future. But those who purchased bonds at the lowest price will be able to claim a multiple win in 2019. As a result, those investors who gave up and succumbed to panic turned out to be the losers. Those who had confidential information or were simply optimistic now can only rub their hands smugly.

Investment specifics

This toolkit is mainly used by experienced players who wish tosecure a high rate of return. Thus, affiliates, large funds and a number of other institutional investors can act as buyers of subordinated bonds. Among private investors, this option is not popular due to the significant entry threshold. Although steps are gradually being taken to increase the number of people involved.

Thus, the Moscow Exchange has recently started using lot splitting, thanks to which one can become a bond owner with such an “insignificant” amount as a thousand US dollars. Who uses these tools and why? The goals of affiliates are already clear from their name. Investment funds want to secure high returns for themselves. So, bonds of super-reliable issuers, an example of which is Sberbank, can provide a good profit. And at the same time - it will be a conservative investment.

Let's say a word about risks

And once again - this toolkit allows you to count on a high level of profitability. But this is only possible due to significant risks. Therefore, it is desirable to choose reliable objects. It should be remembered that not only activities are carried out here, when you can lose part of the invested funds, but all investments. After all, in case of bankruptcy, even the holders of ordinary shares often do not get anything. And there is nothing to say about subordinated bonds. Therefore, it is necessary to seriously approach the choice of the issuer. The same savings bank will provide, albeit not very high, but reliable profit over a long period.

Use this tool only if you havehigh-quality full-fledged information about the state of the subject and broad knowledge in the field of investment. It is also not advised to start working with large amounts. In the best way here can help the rule "quietly you go, you will be farther." It is necessary to gradually gain experience, understand the affairs of the company using only public information - and then the probability of failure will be minimized. Of course, you will not be able to completely protect yourself, and there will always be a certain risk. But it is fully offset by profitability. If we realistically assess the existing risks.

Conclusion

There are many tools in the world that can be used to invest and make money. And the higher the potential return, the greater the risk that a person or organization takes on who wants to increase their fortune. That's the whole point of subordinated bonds.

Although, the same can be said about any financial instrument that is used for enrichment. After all, working with money in our time is an extremely risky activity that requires a wide range of knowledge, the ability to apply and use it effectively.