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Tutorial: Subordinated bonds

What are subordinated bonds?

Subordinated bonds are long-term obligations with a fixed or variabel coupon payment.

Subordination means that in case of the issuer's insolvency claims made by the holder of a subordinated bond will only be fulfilled once all other claims by non-subordinate creditors (e.g. investors holding covered bonds or "normal" senior bonds) have been satisfied. Due to the higher risk of subordinated bonds, the interest rate of a subordinated bond is higher than the interest rate of non-subordinated bonds.

How do subordinated bonds work?

A subordinated bond offers a regular coupon payment which is higher than the interest rate of a senior bond. The coupon can be fix or variable depending on the product type. At maturity the bond will be redeemed at 100% of the nominal value if there is no premature redemption due to legal and/or fiscal changes. In case of an early redemption investors receive a payment of 100% in terms of nominal value.

The credit worthiness of the issuer is essential. The statutory loss sharing involves measures by the regulatory authority to stabilize banks in critical situations. The recapitalisation or the winding-up of credit institutions may involve the reduction or write-off of the nominal value and the conversion into equity. In this case the investors of subordinated bonds may lose their right to redemption and, in case of conversion into equity, may be expropriated.

Special characteristics to be aware of.

The subordinate status vis-à-vis non-subordinate creditors increases the default risk of the issuer.

The regulatory framework and supervisory steps may have significant effect on investor rights and may negatively affect the market value of subordinated bonds even before the occurrence of economic inviability or winding-up.

Advantages

  • periodical coupon payments
  • Higher interest payments in comparison to non-subordinated bonds compensates higher credit risk due to subordination.
  • Redemption at the end of maturiy amounts 100% of the nominal value, if there is no statutory loss participation obligation.
  • In case of an early redemption due to legal and/or fiscal changes investors receive a payment of 100% in terms of nominal value.

Risks

  • Investors have to take a statutory loss participation obligation into account.
  • In case of the debtor’s insolvency the holder of the subordinated bond will be serviced after all holders of non-subordinated bonds have been serviced.
  • Investors are subject to the risk of the insolvency and thus default of the issuer and may incur capital losses of up to 100%.
  • Investors bear the risk of interest rate increases, which would trigger a fall in the market price of the bond.
  • The bond price is subject to fluctuations during the life of the bond, which may result in losses.
  • The redemption of 100% in terms of nominal value only applies to the end of maturity.

Performance throughout the term of the bond

Subordinated bonds react severely on changes of the default risk. If the credit worthiness declines, the price of the subordinated bond decimates.

Interest rates rise.
The price of subordinated bonds with a fixed interest rate falls, when interest rates are rising. If you sell the bond prior to maturity, you may record a loss.
Subordinated bonds with a floating interest rate, on the other hand, benefit from rising interest rates. Given that these bonds ("floaters") have their interest rate periodically adjusted to a referential rate, an increase in the level of interest rates also means a rising interest rate for the bond. The price of the bond tends to oscillate around 100% of the nominal value.

Interest rates remain static.
In the case of stable interest rates, neither the price nor the coupon of the subordinated bond changes.

Interest rates fall.
The price of subordinated bonds with a fixed interest rate increases, when interest rates are falling. If you sell the bond prior to maturity, you may record a profit.
Falling interest rates, on the other hand, have a negative impact on subordinated bonds with a floating interest rate. Given that these bonds ("floaters") have their interest rate periodically adjusted to a referential rate, a decrease in the level of interest rates also means a falling interest rate for the bond. The price of the bond tends to oscillate around 100% of the nominal value.





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