CIO WM Research 20 February 2014
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1 CIO WM Research 20 February 2014 Subordinated bonds Opportunities in financial sector capital securities Rebecca Clarke, corporate bond analyst, UBS FS Fig. 1: The evolving capital structure of banks Capital structure under Basel 1 & 2 and Basel 3 With this report, we would like to broaden investors' focus on the preferred securities market to the larger universe of capital securities that trade in the OTC market. Capital securities primarily differ from the USD 25 par market in that this is an institutional market of USD 1000 par securities, which is larger and deeper that the US retail preferred market. We define capital securities, explain the opportunity, and suggest means for investors to participate in the asset class. Tier 3 capital Tier 2 capital (4%) Lower Tier 2 (2%) s Sifi (1-2.5%) Countercyclical (2.5%) Tier 2 capital Tier 2 (2%) Tier 1 capital (8.5%) Additional Tier 1 (1.5% ) In the current Corporate Bond Valuation Report and Preferred Securities Valuation Report, we based our recommendation for investments lower in the capital structure on the fundamentally improved condition of US and European banks and insurers. We reemphasize this credit-based rationale for capital securities as well, as these securities are also primarily issued by banks and insurers. What are capital securities and how do they differ from US retail preferred securities? Capital securities are similar to preferred shares in that both serve as a source of capital for issuers in most cases after common equity is depleted. Capital securities as a class describes the Tier 1 and Tier 2 securities issued mainly by banks, generally in benchmark USD 1bn issue size or greater, with security denominations of USD 1000 and above. These are sold through syndicates to institutional investors when launched. These bonds make up a market of about USD 250bn in USD and another USD 300bn in non-usd, as compared to the retail preferred market of about USD 200bn. How does this differ from the US preferred market? The US exchange traded USD 25 par market is primarily a retail market, which is susceptible to supply and demand factors and is sensitive to ETF flows in and out of the securities. The Capital Securities index that we are focusing on is more institutionally driven, and is based on larger, relatively more liquid USD 1000 par issues which will be more widely held by institutional investors than retail Upper Tier 2 (2%) Tier 1 capital (4%) Innovative Tier 1 (0.6) Non-innovative Tier 1 (1.4% ) Equity and retained earnings (2.0%) C onservation Bu ffer (2.5%) Equity and retained earnings (4.5%) (M inim um Common Equity Tier 1) Basel 1 / 2 Basel 3 Source: BIS, UCG, UBS CIO WMR A version of this report is available with specific security recommendations for US onshore investors. For a copy, please consult your UBS Financial Advisor. This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 5. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
2 investors. We prefer the institutional market, as we feel these investors will more consistently invest for yield and total return purposes, such that prices are likely to be less volatile, and markets for the securities deeper, and more liquid. In our view, capital securities are now an attractive means of accessing higher yields in the financial sector, where the added structural risk of the subordination of the securities is mitigated by the significant improvement in bank and financial sector company credit fundamentals. Banks and insurers and large cap diversified financials are holding record levels of equity, liquid assets, and have lowered leverage, while the recovery in economic trends has led or is leading to improved quality in loan and securities portfolios, while banks and insurers have been conservative in terms of underwriting standards over the last several years. Please see our report, The changing universe of subordinated financial bonds, 20 September Why does the opportunity exist? For the banks, which have issued the majority of capital issues, regulatory overhaul brought about by the financial crisis under the principles of the Basel Committee is being instituted worldwide, with the goal of making banking regulations more uniform globally. The rules set out standards for capital, liquidity and leverage. For European insurers, the new regulatory framework under Solvency II is being instituted through national laws which parallel in form and intent much of the Basel 3 guidelines. Solvency II prescribes capital and liquidity levels, and will feature similar security structure requirements as used in Tier 1 securities for Basel 3. The rules for banks, in the form of the Dodd-Frank Act in the US and Capital Resolution Directive (CRD4) in Europe, have specified the structural requirements for new compliant Tier 1 capital securities, such that TruPS in the US and a portion of the existing Tier 1 on European banks' balance sheets is now obsolete, and is being phased out. Banks must issue new, compliant Tier 1 and Tier 2 securities to meet higher capital standards and to replace old style instruments. This means that banks are much more likely to call securities at their first call date if they are callable. In addition, we anticipate new supply of compliant securities which will be investible at attractive levels. Fig. 2: Capital Securities index versus Preferred Securities Index (C0CS v P0P1) spread in bps /31/2013 1/15/2014 1/30/2014 2/14/2014 U.S. Corp All Capital Securities Preferred Stock Fixed Rate US Retail Preferred vs Capital Securities Indices Characteristics As of 19 Feb 2014 P0P1 C0CS Number of Issues Amount Outstanding (USD bn) 93, ,886 Market Value (USD bn) 92, ,265 Option Adjusted Spread (bps) Par Wtd Price (%) Mkt Wghted Rating BBB BBB Yield to Worst (%) Modified Duration to Worst (Yrs Mkt Weighted Coupon (%) Fig. 2: Capital requirements under Basel 3 are already in place Phase-in schedule for capital ratios for advanced approaches banks Common Equity (CE) Tier 1Capital Added CE Tier 1 Conservation Total Conservation Countercyclical Capital Countercyclical Capital Add'l Tier Tier 2 Year 1Capital Capital Total Capital % 1.50% 2.5% 0% 0% 8% 0% 0% % 1.50% 2.0% 0% 0% 8% 0% 0% % 1.50% 2.0% 0.625% 0.625% 8.625% 0.625% 0.625% % 1.50% 2.0% 0.625% 1.25% 9.25% 0.625% 1.25% % 1.50% 2.0% 0.625% 1.875% 9.875% 0.625% 1.875% % 1.50% 2.0% 0.625% 2.50% 10.50% 0.625% 2.5% Source: Federal Reserve, UBS CIO WMR UBS CIO WM Research 20 February
3 We see room for investors to invest in US, European and select EM capital securities, which have largely been affected by these regulatory changes. EM and European issuers are in most cases still at an earlier stage of recovery from the financial crisis, but we focus on the higher quality, IG rated capital securities where the global nature of the issuer's business, and their already strong fundamental credit profiles offset some of the market risks in these regions. Further, we see potential for greater spread compression in the recovery stories in Europe and EM, and we see the additional yield as good compensation for the remaining risks, on a selective basis. What are the returns? We compare the return of the broad investment grade market as represented by the BAML IG master index (C0A0) to the return in capital securities using the BAML US Capital Securities index (C0CS), which is a subset of the IG master. We expect that the yield pick-up will be in the 1% - 3% range over a 6-12 month period, based mainly on the higher coupon returns of the capital securities. We expect incremental spread compression in capital securities as well, particularly in a more positive economic scenario or if interest rates are more benign. What are the risks? We already have credit and equity market evidence of the fundamental improvement in the financial sector, particularly in banks, as seen in the performance of their equities and credit spreads in We will emphasize bank issues in our recommendations, as we see these as the most likely to generate the returns we expect. The rules themselves, under the Basel 3 framework, are already being instituted in the US and Europe, and in the larger and more developed EM countries. For European insurers, Solvency II requirements begin their implementation in 2016, and we see market pressure for these companies to comply early with most having already initiated the process. Price volatility - Given the House View outlook for rising interest rates, we anticipate greater price volatility in the near term in capital securities due to their subordinated status, as reflected in the capital securities index (C0CS) than we expect for the broader investment grade index (C0A0). However, we expect lower price volatility in institutional capital securities than we expect in the retail preferred securities market, given the larger and deeper characteristics of the capital securities market. Extension risk - A main risk for investors is extension risk, if securities are not called at their first call date they may remain outstanding for some time, affecting returns and potentially causing realignment of prices (downwards) in recognition of the longer maturity profile. This could happen with old-style securities if a bank determines that a security is a source of reasonably priced subordinated capital or even senior debt, and maintains the security in their capital structure on its original terms, but serving a very different function vis a vis its original intent. For old-style Tier 1 and 2 securities, we expect that most will be called at their first call date, mainly due to the economics of such a decision, in that most banks can issue lower cost debt as senior debt, and have access to markets to do this. In some cases, existing old style Tier 1 securities will gradually phase out from Tier 1 to Tier 2 status, and, for the largest banks, then phase out further from Tier 2 status to Fig. 3: Capital structure seniority for European banks with old and new style capital securities Deposits Senior Unsecured Debt Old Lower Tier 2 Old Tier 1 Bonds / Preferred Securities Tier 1 Contingent Convertibles Common Equity New Tier 2 Tier 2 Contingent Convertibles Source: UBS CIO WMR Owing to bank resolution regimes, old and new Tier 2 bonds rank equal in a liquidation cas e High trigger CoCos support the entire capitalization (incl. low trigger CoCos. ) Old Tier 1 bonds may be grandfathered as Tier 2 and generally benefit from the issuance of higher quality capital Tier 1 CoCos rank low er than old Tier 1s. CRD 4 conversion trigger: 5.125% CET1 Total Returns for capital securities compare favorably to preferred and broader investment grade securities since the financial crisis total return indices rebased to 100 as of 12/31/2008 for C0A0, C0CS, P0P1 Index Value Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 U.S. Corp All Capital Securities Preferred Stock Fixed Rate US Corp Master Fig. 4: Capital Securities index around taper policy change a sample of volatility when interest rates move spread in bps /28/2013 5/31/2013 8/31/ /30/2013 U.S. Corp All Capital Securities Preferred Stock Fixed Rate Source: BofAML, UBS CIO WMR as of 14 February 2014 UBS CIO WM Research 20 February
4 senior status. We think most banks are likely to issue fresh, compliant, and newly structured securities to fulfill the specific functions of Tier 1 and Tier 2 in their capital structures. Bank issuers may write into these new securities terms which enable these to adapt to rising capital standards over time, as we think it likely that for the largest global banks, capital and leverage requirements will be more likely to rise from current levels than to decline. Regulatory par calls - There is also some risk of regulatory par calls on securities before their first call date, based on terms in the bonds which permit the bonds to be called early if they no longer qualify as Tier 1 capital securities. We think regulatory calls will be less widespread in Europe, and that most early calls related to TruPS and other non-compliant Tier 1 securities in the US have already occurred in 2012 and Interest rate risk - A good number of the newly issued Tier 1 securities may be non-callable for 10 years. A security issued at today's rates that is fixed and non-callable for ten years may be subject to higher price risk as interest rates gradually rise. To mitigate this risk, we will look for compliant fix to float structures, as well as higher coupon fixed structures as the latter offer some additional credit spread which could potentially offset some of the yield variance due to rate changes from the security's issue date. We also note that there are very limited number of cases in the past ten years when interest rates rose and credit spreads widened. How to invest? In the table below, we have selected institutional USD 1000 par preferred securities, which we currently cover. These securities are not included in the capital securities index (C0CS) which we use here as the benchmark because they are DRD eligible, and are structured as shares rather than coupon-paying bonds. However, these securities have the characteristics of the institutional market of larger issue size and higher liquidity, but retain a tax-advantaged status which may make them more attractive to retail investors. Fig. 5: Capital securities index yield and maturity profile Yield to Worst % Years to Maturity BAMLCapital Securities Index (C0CS) Log. (BAMLCapital Securities Index (C0CS)) Selected USD 1000 par preferred securities (from "Preferred Securities Valuation Report") Security description Price CY WMR Moody's/S&P/Fitch CUSIP Call date YTC rating GE Capital Corp % fixed to call date; $ Attractive thereafter 3mo LIBOR+470.4bps Baa1 / AA- / NR SP1 12/15/ GE Capital Corp %fixed to call date; $ Attractive thereafter 3mo LIBOR+529.6bps Baa1 / AA- / NR SN6 6/15/ J.P. Morgan Chase & Co. 5.15% fixed to call date; $ Core thereafter 3mo LIBOR+325bps Ba1 / BBB / BBB BAC9 5/1/ J.P. Morgan Chase & Co. 7.90% fixed to call date; $ Attractive thereafter 3mo LIBOR+347bps Ba1 / BBB / BBB HHA1 4/30/ PNC Financial Services 4.850% fixed to call date; $ Core thereafter 3mo LIBOR+304bps Baa3 / BBB / BBB AM7 6/1/ PNC Financial Services 6.75% fixed to call date; $ Attractive thereafter 3mo LIBOR+367.8bps Baa3 / BBB / BBB AK1 8/1/ Wells Fargo & Co. 7.98% fixed to call date; $ Attractive thereafter 3mo LIBOR+377bps Baa3 / BBB+ / NR PM7 3/15/ Source: Bloomberg, UBS CIO WMR as of 19 February 2014 UBS CIO WM Research 20 February
5 Appendix Disclosures (20 February 2014) General Electric Capital 3, 11, 12, 13; JPMorgan Chase & Co. 1, 2, 4, 5, 6, 7, 8, 9, 11, 12, 13; PNC Financial Serv Grp 2, 4, 6, 7, 8, 9, Wells Fargo & Company 1, 2, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13; 1. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and investment banking services are being, or have been, provided. 2. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-investment banking securities-related services are being, or have been, provided. 3. UBS AG, its affiliates or subsidiaries beneficially owned 1% or more of a class of this company's common equity securities as of last month's end (or the prior month's end if this report is dated less than 10 days after the most recent month's end). 4. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities services are being, or have been, provided. 5. UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services from this company/entity within the next three months. 6. This company/entity is, or within the past 12 months has been, a client of UBS Financial Services Inc, and non-investment banking securities-related services are being, or have been, provided. 7. Within the past 12 months, UBS Financial Services Inc has received compensation for products and services other than investment banking services from this company. 8. UBS Securities LLC makes a market in the securities and/or ADRs of this company. 9. Within the past 12 months, UBS Securities LLC has received compensation for products and services other than investment banking services from this company/entity. 10. The equity analyst covering this company, a member of his or her team, or one of their household members has a long common stock position in this company. 11. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity. 12. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month's end (or the prior month's end if this report is dated less than 10 working days after the most recent month's end). 13. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of this company/entity or one of its affiliates within the past 12 months. Statement of Risk Bond market returns are difficult to forecast because of fluctuations in the economy, investor psychology, geopolitical conditions and other important variables. Corporate bonds are subject to a number of risks, including credit risk, interest rate risk, liquidity risk, and event risk. Though historical default rates are low on investment grade corporate bonds, perceived adverse changes in the credit quality of an issuer may negatively affect the market value of securities. As interest rates rise, the value of a fixed coupon security will likely decline. Bonds are subject to market value fluctuations, given changes in the level of risk-free interest rates. Not all bonds can be sold quickly or easily on the open market. Prospective investors should consult their tax advisors concerning the federal, state, local, and non-u.s. tax consequences of owning any securities referenced in this report. Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. UBS CIO WM Research 20 February
6 Appendix Disclaimer In certain countries UBS AG is referred to as UBS SA. This publication is for our clients information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situation and needs of any specific recipient. We recommend that recipients take financial and/or tax advice as to the implications of investing in any of the products mentioned herein. We do not provide tax advice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Other than disclosures relating to UBS AG, its subsidiaries and affiliates, all information expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness. All information and opinions are current only as of the date of this report, and are subject to change without notice. This publication is not intended to be a complete statement or summary of the securities, markets or developments referred to in the report. Opinions may differ or be contrary to those expressed by other business areas or groups of UBS AG, its subsidiaries and affiliates. Chief Investment Office Wealth Management Research Americas (CIO WMRA) is written by Wealth Management & Swiss Bank and Wealth Management Americas. UBS Investment Research is written by UBS Investment Bank. The research process of Except for economic forecasts, CIO WMRA is independent of UBS Investment Research. As a consequence research methodologies applied and assumptions made by CIO WMRA and UBS Investment Research may differ, for example, in terms of investment horizon, model assumptions, and valuation methods. Therefore investment recommendations independently provided by the two UBS research organizations can be different. The analyst(s) responsible for the preparation of this report may interact with trading desk personnel, sales personnel and other constituencies for the purpose of gathering, synthesizing and interpreting market information. The compensation of the analyst(s) who prepared this report is determined exclusively by research management and senior management (not including investment banking). Analyst compensation is not based on investment banking revenues, however, compensation may relate to the revenues of UBS as a whole, of which investment banking, sales and trading are a part. At any time, investment decisions (including whether to buy or hold securities) made by UBS AG, its subsidiaries and employees thereof, may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, groups or affiliates of UBS. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in foreign currency exchange rates may have an adverse effect on the price, value or income of an investment. Past performance of an investment is not a guide to its future performance. Additional information will be made available upon request. This report is for distribution only under such circumstances as may be permitted by applicable law. The securities described herein may not be eligible for sale in all jurisdictions or to all categories of investors. Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-us affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-us affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. Version as per September UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved UBS CIO WM Research 20 February
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