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Subordinated bonds stand as a distinct class of debt instruments that often allure investors with their higher yield potential but come with a unique set of risks. As financial markets continue to evolve, understanding the intricacies of these instruments becomes increasingly vital for investors, issuers, and financial professionals alike.
This article aims to unravel the layers of complexity surrounding subordinated bonds, shedding light on their defining characteristics, roles in financial markets, and existing examples of subordinated bonds in Malaysia. From their distinctive position in the capital structure to the factors influencing their issuance and the implications for investors, this exploration seeks to provide a certain level of understanding of these intriguing financial instruments.
Characteristics of Subordinated Bonds
Subordinated bonds are a type of debt security issued by a corporation or entity that ranks lower in priority for repayment in case of bankruptcy or liquidation compared to other forms of debt.
Characteristics of Subordinated Bonds are explained below:
- Priority in Repayment: In the event of bankruptcy or liquidation, subordinated bondholders are paid after senior bondholders and other creditors. This means they have a lower priority in receiving repayments from the issuer's remaining assets.
- Risk and Return: Because they carry higher risk due to their lower priority in repayment, subordinated bonds typically offer higher yields or interest rates compared to senior debt instruments. Investors demand higher returns to compensate for the increased risk associated with these bonds.
- Issuer's Attractiveness: Issuers might opt for subordinated bonds as they offer a means to raise capital without diluting ownership or control. Additionally, the higher interest rates associated with these bonds can make them attractive to investors seeking higher returns.
- Investor Considerations: Investors interested in subordinated bonds should carefully assess the financial health of the issuing entity. Understanding the issuer's ability to meet its debt obligations and assessing the overall risk tolerance is crucial before investing in subordinated bonds.
Enhancing Financial Strength via Subordinated Bond
Subordinated bonds and Tier 2 capital are closely related within the context of bank capitalization and regulatory frameworks, especially under Basel III norms. Tier 2 capital includes several types of less secure funding for a bank, and subordinated bonds often fall into this category. Tier 2 capital is a component of a bank's regulatory capital, as defined by Basel III standards. It includes less secure forms of capital compared to Tier 1 capital, which primarily consists of common equity and disclosed reserves. Tier 2 capital acts as a supplementary reserve to absorb losses in case of a bank's financial distress or insolvency.
Subordinated bonds, due to their lower priority in repayment in case of bankruptcy or liquidation, are considered less secure than other forms of debt, such as senior bonds or deposits. These bonds have a subordinate claim on the issuer's assets and cash flows, making them riskier for investors. However, their riskier nature often translates to higher yields compared to senior debt instruments.
Subordinated bonds can qualify as Tier 2 regulatory capital for banks. For a subordinated bond to count as Tier 2 capital, it needs to meet specific regulatory criteria set forth by banking authorities, such as the Basel Committee on Banking Supervision. These criteria often include requirements related to the bond's maturity, features, loss absorption capabilities, and other regulatory guidelines. When issued by banks and meeting the necessary regulatory standards, subordinated bonds can enhance a bank's Tier 2 capital. This provides banks with additional capital buffers to absorb losses in times of financial stress, contributing to a stronger and more resilient banking system.
While subordinated bonds, by nature, sit lower in the hierarchy of debt repayment, they can be part of a bank's Tier 2 capital when they meet specific regulatory criteria. This integration of subordinated bonds into Tier 2 capital plays a role in bolstering a bank's financial strength and meeting regulatory capital adequacy requirements.
Subordinated Bonds in Malaysia
In Malaysia, subordinated bonds are mostly issued by financial institutions. As explained earlier, subordinated bonds issuance has the advantage for banks of being recognised as Tier 2 capital. It also has the potential virtue of making banks more subject to market discipline. Banks specialising in longer-term lending will tend to issue long-term bonds to lock in funding.
Here are some examples of subordinated bonds issued in Malaysia:
- Affin Bank Berhad issued RM500 mil subordinated bond in July 2022 at an attractive coupon rate of 5.00%. The proceeds from the issuance were meant to be utilized for the general banking working capital requirements and business purposes. Further details on the issuance can be referred to BIX Malaysia website at https://bixmalaysia.com/security-info-page?SBID=12085#security-information-tab1 .
- Hong Leong Financial Group Berhad issued RM1.1 bil subordinated bond in June 2019. The 10-years subordinated bond carried a coupon rate of 4.30%. The issuance of subordinated bond qualifies as Tier 2 capital for the purpose of determining the capital adequacy ratio of Hong Leong Financial Group Berhad. Further details on the issuance can be referred to BIX Malaysia website at https://www.bixmalaysia.com/security-info-page?SBID=7887 .
- MNRB Holdings Berhad issued RM320 mil of Sukuk Programme which constitutes both Senior Sukuk Murabahah and Subordinated Sukuk Murabahah. The Subordinated Sukuk was intended to qualify as Tier 2 capital instrument and the proceeds from the issuance are utilised for refinancing of MNRB’s existing and future borrowings, investment into MNRB’s subsidiaries and investment in permitted investments. Further information on the issuance can be explored at BIX Malaysia website at https://www.bixmalaysia.com/security-info-page?SBID=7534#security-information-tab1.
Conclusion
Subordinated bonds play a role in the capital structure of an entity, contributing to its financing needs. However, they come with increased risk due to their subordinate position in the repayment hierarchy, making them a riskier investment compared to senior bonds. Subordinated bonds can provide an opportunity for investors seeking higher yields, but they also come with increased risk due to their lower priority status in the event of default or bankruptcy. As with any investment, understanding the risks and conducting thorough research is essential before investing in subordinated bonds.
This report has been prepared and issued by Bond and Sukuk Information Platform Sdn Bhd (“the Company”). The information provided in this report is of a general nature and has been prepared for information purposes only. It is not intended to constitute research or as advice for any investor. The information in this report is not and should not be construed or considered as an offer, recommendation or solicitation for investments. Investors are advised to make their own independent evaluation of the information contained in this report, consider their own individual investment objectives, financial situation and particular needs and should seek appropriate personalized financial advice from a qualified professional to suit individual circumstances and risk profile.
The information contained in this report is prepared from data believed to be correct and reliable at the time of issuance of this report. While every effort is made to ensure the information is up-to-date and correct, the Company does not make any guarantee, representation or warranty, express or implied, as to the adequacy, accuracy, completeness, reliability or fairness of any such information contained in this report and accordingly, neither the Company nor any of its affiliates nor its related persons shall not be liable in any manner whatsoever for any consequences (including but not limited to any direct, indirect or consequential losses, loss of profits and damages) of any reliance thereon or usage thereof.
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