Callable Bond – Part 3: Perpetual Subordinated Capital Note

Perpetual subordinated capital note does not have a maturity date. It has a pre-negotiated coupon (which can be fixed, floating or switches from fixed-to-float in its lifetime) to the holder periodically but the coupon can be switch off if no dividend is being distributed to the ordinary shares at the time. The deferred coupon might be cancelled (non-cumulative) or pay back all at the same time in arrear (cumulative).

It is a hybrid instrument. On one hand, it possesses many characteristics of equity (e.g. not obliged to redeem the principal, fail to pay coupon does not classify as an event of default). On the other hand, its coupon can be counted as an expense against income and would receive the same favourite tax treatment as other debt instruments (if structured correctly). In addition, it is not dilutive to the shareholders. This type of hybrid capital is currently cheaper than ordinary shares as a long term funding source and offers a comparatively attractive yield to credit investors in the current low interest rate environment. It is thus popular to many corporate treasurers. We can find active hybrid capital issuers from a wide range of banks to utility and industrial companies.

Common types of subordinated capital notes

Banks are the biggest issuers of subordinated capital notes at the moment with Additional Tier 1 capital (AT1) being the template for banks governed by EU directives. To qualify as AT1 and be counted towards part of the tier one capital, these notes have to adhere to the strict requirement illustrated in Basel III, CRD IV and other related banking regulations. One of the key requirements of AT1s is the note needs to be either written down or be converted into equity if a RWA based common equity tier 1 ratio (CET1) limit is breached. In addition, its coupon needs to be non-cumulative and do not have a step-up coupon feature. While fixed-to-float coupon is not an issue by itself, the bank cannot create incentives or signals that it will call the note beyond a certain date. Say an AT1 has a fixed 8% coupon for the first 5 years and the current 5Y swap rate is 2%, it implies that the 6% of the coupon accounts for the credit component initially. The coupon format is deemed acceptable if the coupon is 5Y swap rate plus a margin of 6% after reset and not so if the margin is significantly higher. According to Merrill Lynch Contingent Capital Index, the issuance of AT1 is larger than $60bn so far. It is fair to say AT1 is almost a market of its own. The discussion is kept brief here. ESMA provided an excellent review about what AT1 is and some of its associated investment risk.

Subordinated capital notes issued by other corporates can have a more flexible design. However, many companies that issue subordinated capital notes are strived to maintain their investment-grade ratings. The rating agency guidelines thus need to take into consideration because of this reason.

A sample subordinated capital note
The term sheet of a typical subordinated capital note is shown in Figure 1. It is a callable fixed-to-float perpetual subordinated capital note issued by Orange SA. The interest rate can fluctuate a lot during the lifetime of a subordinated capital note. If the interest rate is deemed to be low at issuance, a potential investor would not want to lock in a low fixed rate forever and vice versa. To strike a balance between the demand of the issuer and bondholders, fixed-to-float is a coupon type often being adopted. The issuer agrees to pay an initial fixed coupon and reset it every few years (usu. 5-10 years) in accordance to a pre-determined formula (e.g. the 5-year swap rate plus a margin at the time of reset for this bond). We can decompose the coupon of a subordinated capital note into a credit and interest rate coupon. An issuer does not want to be bound by a long term commitment to high subordinated capital note coupon payment if its perceived credit risk reduces, the general market demands a lower risk premium, or it simply needs lesser longer term financing. To provide a degree of financial flexibility, the majority of subordinated capital notes are callable after the initial non-call period.

Figure 1: Termsheet for a typical subordinated capital note (ORAFP 5.25 perp is being shown here).
Figure 1: Termsheet for a typical subordinated capital note (ORAFP 5.25 perp is being shown here).

Pricing and analytics
Before looking into the pricing and analytics for subordinated capital note, let’s review the pricing formula for a vanilla perpetual bond.

-Pricing a perpetual bond
The price of a perpetual bond can be calculated as the discounted cash flow from all its coupons in the future.

For a perpetual bond pays a fixed coupon of c per annum and with a market yield of y at the time, the price of the bond P can be calculated as the sum of the geometric series = c/(1+y)+ c/ (1+y)^2 + c /(1+y)^3 + … = c/y. Recalling that modified duration is defined as -1/P dP/dy. For any perpetual bond, the modified duration is thus 1/y.

In theory, if the market demands a zero yield, the price of a perpetual bond would become infinitely expensive. This is impossible even in an artificially low interest rate environment. The interest rate for the short end of the yield curve may dip below zero but investors would demand a certain positive yield for perpetual as it is clear to anyone that even the government bond issued by stable and prosperous developed country are not risk-free. Investors would also demand some extra yield to compensate for liquidity, funding and other risks.

-Extending to a callable perpetual bond
Similar to an ordinary callable bond, we can use a one-factor interest rate tree to price a callable perpetual bond. There are a number of points we need to pay attention to.

Since we have no certainty about the interest rate far into the future (say 100 years) and the cash flow are supposed to be heavily discounted, we may replace the redemption price with the perpetual bond price assuming the required bond yield is the same as the interest rate at each of the terminal node. Since the perpetual bond price formula would become intractable if any terminal node has zero or negative rate, we should select interest rate models (such as Black-Karashiski) with a strictly positive rate for any nodes.

Many subordinated capital notes adopt the fixed-to-float coupon format with the coupon being reset every 5 to 10 years based on the 5 to 10-year swap rate at the time. Since the one-factor interest rate tree being used is for the short rate only, we would need a two-factor interest rate tree (of which both short and long rate being modelled at the same time) to model for both short term interest rate and the swap rate. In practice, we can approximate the reset rate as the short rate plus the margin at the reset date. We may add an adjustment to account for the term structure of the yield curve. Such approximation is justifiable as long as credit rather than interest rate is more of a concern for the subordinated capital note we are analysing.


Figure 2a: Price-OAS plot. Figure 2b: Spread Duration – OAS plot for a callable perpetual subordinated note (ORAFP 5.25 perp as of 2014-05-15)
Figure 2a: Price-OAS plot. Figure 2b: Spread Duration – OAS plot for a callable perpetual subordinated note (ORAFP 5.25 perp as of 2014-05-15)

The price-OAS and spread-duration plots for the sample ORAFP bond are shown in Figure 2a and b.  For this capital note with multiple par calls, we can only identify a transition in the spread-duration plot.  If there are improvements in credit (and OAS tightens), the capital note would be called at the first call date as the bond price will rise above par.  If that is not the case, it would behave as if it is an ordinary perpetual bond (as illustrated by the portion to the right of the peak duration).   The spread duration of a perpetual bond falls rapidly and is inverse to the OAS.