New bank rules bring equity-like risks to fixed income securities

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By Ryan van Breda, Fixed Income Analyst, Prescient Investment Management

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ryanBasel III has changed the regulatory environment governing banks and warrants very close attention by investors.

The implementation period for several Basel III requirements that were incorporated into the regulations commenced on 1 January 2013 and includes transitional arrangements which will be phased in until 1 January 2019.

Basel III requires banks to match term liabilities with term assets and to hold a higher absolute level of capital. Furthermore Basel III requires that bondholders share in the losses of a bank should it need to be recapitalised in times of stress. These new types of loss-absorbing instruments are commonly known as “new style” tier 2 bonds. They are subordinated to senior bonds and now include potential write-off provisions, meaning that investors are now effectively exposed to equity-like risk in a bond under certain scenarios.

The loss-absorbing requirements will not only pertain to the new bonds but will also in time to preference shareholders. Solutions regarding preference shares will be pursued to arrive at a solution that is fair to investors and that meets the Basel III write off-requirements.

Preference shares and “old style” tier 2 bonds, which do not meet the Basel III requirements, are to be phased out evenly over 10 years with effect from 1 January 2013 in accordance with the transition rules. Banks will naturally replace these bonds and will in time have to restructure their preference shares, given their capital inefficiency.

The terms and conditions of the new bonds require, at the option of the SARB, that they are either written off or are converted into the most subordinated form of equity upon the occurrence of a trigger event.

The trigger event would be declared by the SARB, unless legislation is in place that requires the bond to be written off at the trigger event or requires the bond to fully absorb losses before tax-payers and ordinary depositors are exposed to loss. The recovery and resolution framework of SA Banks has yet to be drafted, and at this stage the requirements for a trigger event remain unclear.

It is clear that the SARB, in line with international principles of recovery and resolution frameworks, has placed losses onto bondholders.

Investors in these new bonds are exposed to equity-like risk and are therefore required to be compensated. However, when these types of bonds were first issues, it appeared that investors did not drill down into all the new terms as some of these new bonds were initially issued at irrationally low levels. The spread offered on subsequent new issues has however increased post African Bank and, in some cases offer value.

At Prescient Investment Management we adopt a conservative credit process, balancing yield versus risk. With uncertainty around the recovery and resolution framework, which has yet to be legislated, and a lack of clarity on the trigger point, investors should be wary of taking on equity-like risk in a fixed income security.

About Prescient Limited

  • Prescient’s subsidiaries include: Prescient Investment Management (SA), Prescient Securities, Prescient Management Company, Prescient Life, Prescient Fund Services, Prescient Wealth Management, Prescient Profile, Prescient Property Investment Management and EMH Prescient Investment Management.
  • Prescient Investment Management is a signatory to the United Nations Principles of Responsible Investing (UN PRI) and pledged to the Codes for Responsible Investing in South Africa (CRISA).
  • Prescient Investment Management was named Overall Investments/Asset Manager of the Year at the Imbasa Yegolide Awards 2011, Absolute Return Manager of the Year in 2013 and Bond Manager of the Year and Responsible Service Provider of the Year in 2015.
  • Prescient has a Dublin registered fund management company, Prescient Fund Services, and a representative office in Shanghai, China.
  • Prescient Investment Management was the first institution in Africa to be granted a Qualified Foreign Institutional Investor (QFII) licence by the China Securities Regulatory Commission (CSRC).
  • For more information, visit www.prescient.co.za