In a world where corporate bonds look expensive and it’s tough to find yield, one firm has been digging around in an overlooked corner of the bank bond market.
Phil Mesman and his colleagues at Picton Mahoney Asset Management have been scooping up subordinated debt issued by the likes of JPMorgan Chase & Co., Barclays Plc, and Credit Agricole SA in the 1980s and 1990s that is trading at a discount to face value. The goal is to get repaid early at a premium to the current price. This strategy, which began almost two years ago with a spreadsheet plotting the rather tiny universe of the asset class, has handed the firm’s funds returns of more than 20 percent, Mesman said.
These legacy hybrid capital notes were originally issued to convert to equity in the event of a bank failure. They trade at a discount primarily because of the low coupon, which is based on a spread over the London interbank offered rate, and uncertainty around whether or not they will be repaid early, Mesman said.
The bonds, which also have a liquidity discount, have a maturity of 25 years or longer in most cases, and some are perpetual bonds, he said. The bond covenants and structures are good for investors, because they make it difficult for a bank to convert the bonds to equity in the event it needs to shore up capital levels. Regulators have said that banks need to take out the bonds before Jan. 1, 2022, Mesman said, putting a deadline on opportunities in the trade.
“It’s an incredible risk-reward,” Mesman, senior partner and portfolio manager, said by phone from Toronto. He manages more than C$700 million ($518 million) in fixed income of Picton’s C$6.8 billion of assets. “Typically they would be rated BB or higher-quality high-yield instruments, but the bank issuers are all investment grade.”
Mesman estimates that his firm is one of only a few players in the $5 billion to $7 billion market, with most of the investors and dealers concentrated in Europe. The bonds represent about 30 percent of both Picton Mahoney’s main fund, the Fortified Income Fund, and the Income Opportunities Fund, as well as about 50 percent of the firm’s special-situations fund, he said.
It’s a strategy that can only be pursued by knowledgeable investors who have flexibility with their investment horizon and don’t have to follow an index, Roger Francis, a credit analyst at Mizuho International Plc in London, said by phone. He said he’s heard the strategy compared to stamp collecting.
“They’re rare and you find them in the back of drawers,” he said. “It’s a relatively small asset class.”
The main risks with these old bank bonds is liquidity — they’re difficult to trade in tough market conditions — and that a bank will opt not to call or tender for them early, Francis said. The strategy hinges on correctly identifying which bonds are candidates to be repaid early, or which banks might be willing to negotiate, Mesman said.
“If we find a bond where perhaps 50 percent to 60 percent of the issue has already been tendered over the years, then we’ll approach them directly and offer them our bonds at a certain price,” he said.
Credit Agricole recently tendered for 371.23 million euros of a perpetual bond at 78 cents on the euro, but investors only took them up on part of the offer, suggesting that they’re waiting for a higher payout, Mesman said. His firm sold 25 percent of their 25 million euro position in the bond and are waiting for a higher price for the rest, he said.
To be sure, there has been some headline uncertainty with some banks in Europe, Mesman said. Deutsche Bank AG, UniCredit SpA, and other European banks have in the past been at risk of not paying the coupons on their bonds. While failure to pay interest would be tantamount to default for most debt securities, coupon payments on newer contingent convertible bonds, known as CoCos, are discretionary. Once missed, though, they are gone forever.
With their strategy, Mesman and colleagues focus on buying older notes generally from U.K. and U.S. banks. They also hedge using tools including bank stock and currencies, he said.
“We’re looking for situations where they’re taking them out sooner, ideally within the next 12 months,” he said.