The Bank of England’s financial policy committee, the UK’s new banking watchdog, has picked up the baton from its predecessors at the financial services authority in calling for banks to be better capitalised and, while it might be helpful if the banks had some guidance on just how much capital could be considered enough, it is difficult to criticise the underlying sentiment.
One aspect to have particularly attracted regulatory interest is what is becoming known in the market as ‘contingent capital’. This is effectively a bond (counting as capital for a bank) but with a twist. Should the issuing bank’s capital ratios drop below a certain level, the bond is wiped out and the debt’s holders receive nothing whatsoever in return.
Capital instruments along such lines have cropped up a few times in recent years but the first of the new breed the regulator has been pushing for has been issued by Barclays. Pulling out the key points from the prospectus, the 10-year bond goes out to November 2022 and the upside for investors is that it pays a fixed coupon of a little over 7.5% a year.
However, while this upside is bond-like, the downside in the event of financial distress – in this instance, if Barclays’ core tier 1 ratio drops below 7% – is that the contingent capital investor ends up with nothing. In contrast, Barclays just carries on because the removal of the bond liability effectively serves to inject capital into the business. That is what these instruments are designed to do.
Barclays was on record as saying it was unsure what the demand would be for its bonds but, as it turns out, they were oversubscribed with $3bn-worth (£1.9bn) launched in total. In the current environment, where people are desperate for income, it is understandable that investors are keen to access premium yields.
Nevertheless, upside of 7.5% income a year versus downside of potentially losing your entire investment seems asymmetrical – not least when making a similar analysis of Barclays’ equity. The bank’s shares currently yield some 2.75%, which is a real yield – meaning it will grow with inflation. The bond’s 7.5%, on the other hand, is nominal so inflation will eat into that every year to 2022.
Taking inflation at, say, 2.5% a year, investors in the bonds are really seeing around two and a quarter percentage points a year more in yield than the equity investors, with essentially the same downside. But – and it is quite a ‘but’ – the equity investors also have all the upside of any resolution to the current banking environment over the next 10 years.
In itself, the launch of the bonds looks to be good news for Barclays’ equity holders for three reasons, the first being that more capital means a greater ‘buffer’ for them should things go wrong. Second, the fact there was so much demand for the bonds suggests the launch was priced reasonably cheaply. We would also argue it serves to highlight the undervaluation of the bank’s equity – particularly when compared with these bonds.
Finally, one would have to assume those investors who bought the bonds do not believe the downside case will actually happen – otherwise they would not have bought them. If the bond market is correct and Barclays avoids potential potholes, then the equity should significantly increase over the course of the next decade, which is the time horizon of these bonds.