What are subordinated bonds and why are they risky?

The bond market is constantly growing and many small and medium investors are approaching this type of investment every day. A significant part of this reality is represented by subordinated bonds, an instrument that follows its own functioning and a risk profile that is yet to be deciphered.

A good investor, regardless of his objectives, must know the instrument with which he wants to operate before carrying out any type of operation. This is why it is important, therefore, to learn how to invest in bonds: in our guide, we will analyze subordinated bonds, which are divided into different types and represent a path that many users like.

Subordinated bonds, what are they? Definition and Meaning

Subordinated bonds are a fixed income investment instrument issued by financial institutions or companies that are distinguished by their level of risk and particular repayment hierarchy in the event of the debtor’s insolvency.

In fact, these bonds are in a subordinated position with respect to other corporate debts; this means that, in the event that the issuing entity finds itself in financial difficulty or declares bankruptcy, the holders of subordinated bonds will be repaid only after the creditors with higher priority (such as holders of ordinary bonds and other senior debt) have been satisfied.

Essentially, subordinated bonds are an investment in loans made to a company or financial institution, with the understanding that interest payments and principal will be repaid only after other debts have been repaid. To compensate for the higher risk of default, these bonds offer a higher interest rate than senior bonds or non-subordinated bonds. It is no coincidence that subordinated bonds are often called "junior".

In terms of yield and risk, subordinated bonds are in a intermediate position between traditional bonds and stocks.

Subordinated bonds: the types to know

With the Basel 3 rules on minimum capital requirements, the types of subordinated bonds have become two: Tier 1 and Tier 2. Previously, there were 4 types and, since they are still in circulation, as they are present in the portfolios of some savers, we briefly explain the types.

• Tier 1 subordinated bonds: these are the riskiest. There are often no maturities and in particular situations the issuer can postpone or even cancel a coupon.

• Upper Tier 2 Subordinated Bonds: after Tier 1 bonds, these are the riskiest. In the most particular cases, the issuer can decide to postpone a coupon but not cancel it. A final maturity is not always foreseen, however, there is almost never a risk of losing the capital.

• Lower Tier 2 Subordinated Bonds: these are among the most common bonds. They often have a ten-year duration and interest is suspended only in serious cases of insolvency. They have a fixed maturity or include an early repayment clause on the first permitted date that the bank is obliged to practice.

• Tier 3 Subordinated Bonds: these are the least risky and least profitable bonds as they are not considered by banks as part of the regulatory capital. They have a short maturity ranging from 2 to 4 years.

Subordinated bonds, between risks and advantages

Like all bonds they are debt securities issued that allow those who buy them to become creditors and acquire the right to reimbursement of the invested capital plus periodic interest or coupon.

Why are they risky?

Unlike ordinary bonds, subordinated bonds have a high degree of risk because, in the event of bankruptcy of the issuer, the holders of subordinated bonds will be compensated only after other types of creditors.

In some cases, the investor may suffer irrecoverable losses. According to European regulations, with the introduction of the Bail in - which became operational on 1 January 2016 - after shares, subordinated bonds are the ones that contribute to the rescue of a bank in serious financial distress.

Remunerative but not always safe

In any case, investing in subordinated bonds has both advantages and risks. One of the main advantages is the higher interest rate, which makes these bonds more attractive than safer but less profitable instruments. However, the associated risk is high: in the event of financial difficulties, the investor may not be reimbursed, or the reimbursement may be partial. Furthermore, the subordinated nature of these bonds makes them vulnerable to market fluctuations and possible corporate or economic crises.

An additional risk lies in the clauses that accompany subordinated bonds, including the possibility for the issuer to suspend interest payments in conditions of financial emergency. For this reason, subordinated bonds are generally recommended for investors with a higher risk tolerance and in-depth knowledge of the market.

How subordinated bonds work

At this point, it is useful to know some important characteristics that distinguish subordinated bonds.

1) They are very complex instruments

• They are “intrinsically” very complex instruments, due to the very nature of the yield linked to the high degree of risk. The degree of risk to which one is exposed is not always clear from the relevant documentation. To fully understand how they work, one must have a good understanding of the operating logic of central banks and credit intermediaries. For example, in the case of Tier 3 subordinated bonds, the repayment of the capital at the maturity of the instrument must be authorized by the central bank on which the issuer depends.

2) They do not always have a certain date of repayment of the capital: “extension risk”

• Many subordinated bonds do not have a real maturity since the maturity sometimes does not exist or is too far away. When the maturity is not specified, a procedure called call is provided for, which allows issuing companies an option for early repayment starting from a certain date. In recent years, the practice of extension risk has become widespread, that is, the uncertainty about the actual maturity of the investment that makes it difficult to estimate its yield.

3) Most subordinated bonds are “illiquid”

• Often these types of bonds are illiquid, which means that savers have difficulty reselling them when needed. A problem that should never be underestimated!

4) They have a high degree of risk that is difficult to diversify

• Credit risk is very high. In the event of a default or bankruptcy, the investor can lose 100% of the invested capital. In fact, the risk involved in this type of instrument is very similar to that of an equity portfolio.

Control of the companies issuing subordinated bonds

The risk rate is also linked to the quality of the issuing company; it is obvious that if the company is a small economic reality or has recently debuted in the bond sector, subordinated bonds will be riskier and, consequently, also more profitable.

Therefore, before buying subordinated bonds, the advice is to carefully know the company in which you are investing and how it operates. Discover, above all, what the sentiment of investors is towards that company and be able to understand what the real chances are that it will fail.

The main issuers of this type of bond are banks; in fact, these often resort to such securities because they are included in the calculation of their supplementary capital, thus allowing them to increase their regulatory capital without resorting to capital increases.

Original article published on Money.it Italy.
Original title: Cosa sono le obbligazioni subordinate e perché sono rischiose