Ordinary (or plain vanilla) senior bonds
Defined as the safest bonds, these bonds provide for repayment, in the event of default by the issuer, with the assets deriving from the liquidation of the assets, or with the money obtainable from the sale of bank assets. In this category, covered and senior secured bonds are also guaranteed by some assets of the issuer's own assets and are therefore more secure, while unsecured senior bonds do not have real guarantees.
Senior bonds, with maturities and coupons of various types, do not contemplate the non-payment of a coupon, resulting in a default. Usually they offer a lower yield together with a higher rating than other bonds, but generally a bank bond is in line with the yield of the BTP with the same maturity.
Ordinary senior bonds can, in turn, be divided into two types, determined at the time of subscription, without elements of particular complexity: – at a fixed rate: they grant the investor interest in a pre-established amount; – variable rate: in relation to market rates, at parity other conditions, grant returns in line with market trends. At the end of the XNUMXs, a push towards new financial engineering products brought about new types of financial instruments, called "structured", as an alternative to government bonds and certificates of deposit.
Structured bonds have particular and innovative methods regarding the calculation of the coupon or the redemption value. They can also present a considerable complexity, given by the understanding of the characteristics and convenience of the security which is not always simple and immediately intuitive to the common saver, with an objective difficulty of evaluation even for insiders.
structured bonds
Structured bonds are less simple and difficult for investors to understand than senior bonds. In particular, their "structure" is based on the concurrence of two elements: – a traditional bond component, which can provide for the payment of annual, half-yearly or quarterly coupons and which guarantees the repayment of the nominal value of the security; – a derivative contract, which bases the investor's remuneration on the evolution of one or more financial or real parameters (eg mutual funds, exchange rates, shares, stock market indices or commodities). Before investing we must be sure that we have learned the risks, the possibilities of return, the functioning and the structure.
The main types of structured bonds are:
– (Equity) Linked: bonds with guaranteed principal linked to a credit derivative, the yield of which is linked to the performance of the stock market. The bond part ensures the repayment of the nominal value at maturity, while the optional part ensures the possible premium;
– Reverse Floater: these are medium/long-term variable-rate bonds, the yield of which is inversely proportional to the trend in market rates;
– Reverse Convertible: these are bonds with unsecured capital which assign the right to have a higher remuneration compared to bonds of the same duration in exchange for the issuer's possibility to repay the holder at maturity through shares even with a lower value than the amount initially invested.
It should also be considered that structured bonds are mainly issued by banks and, on the basis of article 100, paragraph 1, lett. f of the TUF, the relative offer to the public does not require the publication of a prospectus, without the obligation of prior transmission to CONSOB. Not all structured bonds are listed on regulated markets and, if they are, any issue liquidity is not high.
This eventuality can create difficulties in the event of the need to sell the security in advance, as the current market prices may not reflect the real value with the risk of having the issuer of the same as the only buyer. The types of structured bonds Various types of bonds belong to the structured category, and some of them retain the typical characteristic of the bond, such as the repayment of the invested capital, presenting various aspects of complexity for the determination of interest.
Examples of this type are bonds whose yield, as linked to facts not known at the time of issue, is indeterminate (reverse linked and floater bonds), or those with coupons initially determined but inconstant over time (the so-called step down and step up). Others, on the other hand, present a substantial difference with respect to the classic concept of bond, since they do not guarantee the full repayment of the capital. This constitutes a characteristic that radically varies the risk profile of the investment and, especially in the past, there has not always been awareness and complete information about it.
Reverse convertibles belong to this type; due to the fact that their structure has often not been correctly evaluated by retail investors, and also considering the low issuance volumes, they will be analyzed separately from the brief overview on other structured bonds. Linked bonds These are particularly structured debt securities whose return is directly linked to the performance of an external index, linked to the performance of certain financial instruments, such as shares (equity linked), indices (index linked), exchange rates (forex linked), commodities linked, mutual funds (funds linked). If the trend is positive, whoever bought the security receives an extra return in the form of additional coupons or a final repayment higher than the price at which they bought it; otherwise, the remuneration will be modest or nil, without prejudice to the guarantee of repayment of the invested capital.
The interest rate paid is usually lower than the market rate, while repayment of the loan at par is guaranteed at maturity. Index linked options allow you to place a bet on the future trend of the markets, thanks to the presence of a "call" option. In reality, this option is not free, and whoever issues it recovers the cost by giving the investor an interest rate lower than the current market rate.
The investor therefore bears the risk of the option: over time it loses value and only if the performance of the underlying stock exceeds the exercise price established at the issue does he receive the promised coupon flow back. Some other simpler types of issues provide for the payment of the premium only at maturity, without the payment of period coupons and therefore, in fact, the premium also includes the flow of unpaid interest during the term of the loan. The reverse floater These are bonds characterized by an initial fixed coupon flow of a large amount which, starting from a certain date, are transformed into securities with variable remuneration, linked to the trend in interest rates, but with a reverse parameterisation procedure: if when interest rates rise, the coupons decrease and, conversely, if interest rates decrease, they increase.
Normally, it coincides with, or is in any case linked to, a market rate (eg the Euribor rate). From now on, the real coupon consists of the difference between the fixed rate of the security and the variable rate that the subscriber must pay to the issuer, and is linked to the trend in market rates. The fixed reverse floater benefits from the constraint that the coupons cannot be negative and linked inversely to short-term interest rates; the bond therefore always has a minimum coupon of zero. In some emission regulations . including the floor option, which provides for the recognition of a minimum coupon of an amount greater than zero. Bonds of this type are made attractive to the market due to a fixed coupon flow higher than current market rates.
This hypothetical advantage, however, represents the payment of a premium for a possible financial risk assumed by the subscriber. The evaluation of an investment must be made on the basis of the yields offered by a security throughout its life and residual duration, and not only on what it yields at the beginning of the issue in the first few years.
The retail investor must be particularly attentive to the fact that the inverse indexation of reverse floater securities is linked to the trend in rates expected by the market in the future. The normal forecasts, on the other hand, of an ordinary person refer to current rates, not so much to expected ones. So it can happen that this situation occurs: one buys a reverse floater, two days later the interbank rates drop by one point and the reverse floater decreases in price. This happens because the future rates expected by the market have increased, even with the presence of a decrease in current rates, and therefore the value of the future coupon flow indexed as opposed to the reverse is reduced.
This risk on the future trend in interest rates would lead the subscriber to receive an effective coupon lower than the present market one and furthermore to not receive any coupon if the variable rate is equal to or higher than the fixed rate initially established. Furthermore, the reduction in the coupon entails a decrease in the capital account value of the security and, in the event that the subscriber needs to sell without waiting for the maturity date, he would receive the current market price, certainly lower than the one paid for the purchase of the bond and, therefore, would suffer a loss, even considerable. This risk of capital loss due to the unfavorable trend in interest rates, however, is typical of all fixed rate bonds and is particularly relevant for long maturities.
The assessment of the issuer is essential before making any investment. Each counterparty tries to raise funds using the cheapest instruments. Therefore, if Bank X has issued a reverse floater, it means that in this way it is able to raise funds at more advantageous costs, obtaining a lower yield, compared to those it would have had to pay with a "normal" issue of fixed-rate securities. The high initial coupons actually represent an early repayment of the principal: if you liquidate the security after having collected them, the value of the same will therefore have discounted the first coupons and therefore will have a market value of less than 100. Furthermore, reverse floaters have little liquidity , and therefore only a limited percentage of the investor's capital needs to be allocated.
Reverse convertibles
Reverse convertibles are financial instruments that promise the subscriber a high coupon. However, they are classified among those atypical securities due to the fact that they present the risk for the investor of receiving on maturity, instead of the capital initially paid up, a number of shares whose value could be lower than the value of the initial investment. For this reason it is subject to a higher withholding tax (27%) than bonds. This typology, under the aspect of a bond that seems particularly attractive, actually presents. an investment in derivative instruments. In particular, the subscriber of a reverse convertible pays a capital to the issuer which will give an attractive yield at maturity. At the same time, however, it sells to the issuer a put option on a security which represents a derivative instrument under which the buyer of the option acquires the right, but not the obligation, to sell a security (called the underlying) to a given strike price, while committing to purchase the stock, if the option purchaser decides to exercise his right, but has in the meantime collected the mandatory premium from the purchaser.
The high return, however, must be related to the fact that the issuer of the reverse, with the purchase of the put option, has the possibility of delivering a quantity of shares predefined by the contract or their equivalent in cash upon expiry. Certainly the issuer has an interest in exercising the option only in the event that the value of the share falls below a predetermined level. Therefore, investors in a reverse convertible believe that the value of the underlying share will remain constant or that it will increase. In summary, reverse convertibles are different from traditional bond investing. In fact, they do not guarantee the return of the invested capital which may decrease given the negative performance of the underlying share. Theoretically, the invested capital can also be zeroed (subject to perception of the periodic coupon), in the event that the value of the underlying share is canceled on expiry. Even this additional feature must be carefully analyzed by those who want to make this investment.
Subordinated bonds
Subordinated bonds are securities in which the payment of periodic interest and the repayment of the capital, in the event of particular financial difficulties (liquidation or bankruptcy), depend on the satisfaction of the other non-subordinated creditors, also including normal bonds defined as senior. Their risk should cause them to yield more than a non-subordinated bond from the same issuer with similar characteristics. Compared to plain vanilla bonds, they have a higher risk and the main reason is that they are instruments treated like capital and often represent an alternative to the more expensive placement of treasury shares. Banks usually issue bonds and they can issue bonds with different degrees of risk, or subordination, but there are two fundamental elements that the saver must keep in mind:
– the type of risk borne depends on the bond purchased (above all the issuer's default risk);
– the yield that can be expected. The types of issues Each is accompanied by different financial characteristics and therefore, according to the level of subordination of the bond, the repayment priority will be different for the investor in the event of bankruptcy of the issuer.
By classifying these bonds with the latest minimum capital requirements rules, the so-called Basel 2 and Basel 3, the distinction between the different categories of subordinated bonds has changed and the types are reduced to two sections, whereas previously the number amounted to four, as shown below. Some bonds of the third and fourth type may still be present in some investors' portfolios.
Tier I bonds
In the presence of critical management trends and in the event of liquidation, they guarantee their holders a preference over holders of ordinary and savings shares, but are subordinated to all other receivables. They represent the riskiest type due to the fact that they have characteristics closest to debt and equity securities. If the bank does not pay the dividend to the shareholders, the coupon may be cancelled.
Having the lowest level of subordination, they are the first to suffer the consequences of liquidity problems. They are issued with no actual maturity date, even if the issuer has the option of early repayment after a certain period of time from issue (10 years). A transformation into a floating rate is envisaged with a step-up (i.e. the incorporated coupon increases over time) and furthermore, depending on the indications of the issue prospectus, the issuer could be obliged to cancel the payment of the coupons in some cases details.
These coupons, contrary to the other subordinates, cannot be accumulated, and the entitled party loses them. Furthermore, if losses capable of damaging the issuer's capital solidity are incurred, the capital to be repaid is reduced, pro-rata, by these losses. A risk to be carefully considered.
Upper Tier II bonds
They are less risky than the former, have a minimum duration of 10 years, in the event of negative trends they do not provide for the cancellation of the coupons, but provide for the possibility for the issuer to block the payment of the coupons in the event of insufficient profits or in the event of suspension of dividend payments on ordinary shares. Failure to pay a coupon does not constitute default, but the coupons are accumulated and paid after the first year of profit. In this case, no recapitalization is envisaged. They are redeemed earlier than stocks and Tier I bonds.
Lower Tier II bonds Also with a maturity of around 10 years, they are the most privileged category within the subordinated bonds. In fact, the coupons are blocked only in the event that a serious case of insolvency or default is announced. Lower Tier III bonds These are bonds similar to Lower Tier II bonds, but may have maturities of less than 5 years. The various types of subordinated bonds can therefore be summarized in the table visible in the photo:
To invest in subordinated bonds, it is necessary to note at least 5 elements that must be carefully evaluated before buying them. Subordinated bonds are complex instruments and in some cases difficult to value for the common investor. Even if in recent years the legislation on investment banking transparency has come to meet average savers, it is not always easy to fully understand the technical characteristics of these securities which are explained in the issue prospectuses using very often Anglo-Saxon terms typical of the world of finance with references to articles of the Civil Code and banking legislation. To fully understand them, it would be necessary to have a clear understanding of the operating logic of credit intermediaries. Very often it is not always clear from the documentation the real risk to which one is exposed, and therefore the role of the subjects in charge of bank supervision is very important to facilitate understanding. Credit risk can lead to high losses.
In the event of bankruptcy, the loss that the investor may suffer is always large and very often close to 100% of the invested capital, since other creditors are privileged, and the capital ceiling aimed at mitigating the lenders' losses is quite limited. The credit risk is very high for Tier I bonds and for some Tier II bonds.
If the repayment date of the principal is uncertain, they are difficult to evaluate in terms of yield comparison Many subordinated bonds do not have a real maturity, but offer the possibility of being recalled by the issuer on certain dates with the so-called "call" option ”. It therefore becomes difficult to estimate the return on investment. If until the beginning of 2008 there was the habit of calling bonds on the first call date, considered by investors, as if it were the real maturity, the financial crisis has changed this status. Some issuers have thus decided not to repay the bonds in advance even though they could do so; in other cases, insolvent companies that were bailed out in extremis by public intervention, not only did not repay the bonds on call, but also informed investors that they will have to suffer capital losses, even though there has never been a real insolvency.
Liquidity of issues is low Subordinated bonds can be particularly difficult to buy and sell, each issue having unique characteristics that set it apart from the others.
Risk diversification is difficult In most cases, even a well-educated investor is able to control the risk of these bonds. Indeed, this investment is more reminiscent of an equity portfolio than a corporate bond portfolio. Even recently, some inexperienced investors have experienced firsthand how the price of these bonds, in phases of extreme volatility, tends to decrease, without any reference to the particular characteristics of the securities and issuers, making it very difficult to manage risk. Typical Risks in Bonds Like any financial asset, bonds carry risks.
It is good to immediately declare that security and profitability are normally opposite concepts: high interests are the counterpart of equally high risks. Typical risks are:
Interest rate risk and credit risk
Interest rate risk represents the possibility that the price of the security will decrease with changes in interest rates. Fixed-rate securities, especially long-term ones, are more exposed to this risk than floating-rate securities. In fact, if market interest rates change:
– fixed-rate securities do not change the coupons and, therefore, to adapt their yield to the new interest rate levels, the price changes;
– floating rate securities adjust the coupons to the new level of interest rates so that the price changes only to a limited extent.
Credit risk Credit risk (or issuer risk) represents the possibility that the issuer is unable to fulfill the obligations assumed, in whole or in part, in the payment of interest and/or principal.
