Skydiving in a squirrel suit: understanding the risks of NVCC bonds

Banco Popular Espanol SA, the sixth largest bank in Spain, failed last week—you might not have heard the news  with the testimony of James Comey to U.S. Congress dominating headlines. The Spanish bank had been struggling for years with a balance sheet that was burdened by toxic mortgages. It finally conceded defeat last Wednesday when Banco Santander paid a whopping 1 euro to take over the bank. Stock and junior debtholders were saddled with losses of around €3.3 billion.

The collapse of Popular serves as an important reminder for investors: it is critical to understand what it is that you are buying. Not only did equity holders lose their shirts in the ruin of the bank—as one might expect—but many junior bondholders did too. This was due to the structure of these junior debt securities. We wager that many bondholders did not anticipate losing their capital when they originally chose to lend the bank money.

It is easy to think of all debt securities as basically the same. After all, people typically invest in bonds for the same reason: safety. There is an implicit assumption when holding a bond that it is safer than equities and you will get your money back; you might not share in the upside, but you at least expect your principal back and coupon payments. However, this is not always the case. The features of some bonds make them inherently riskier than others.

Since 2010, there has been growth in a certain breed of bond in debt markets. This bond has a unique risk profile: it is a bond until a crisis scenario is triggered and then it turns into equity. If that sounds unappealing to you, we wouldn’t blame you. Most people purchase bonds because they want to avoid the risk of equities in a crisis, i.e., they want protection when things go south. Yet because these bonds become equity in a crisis, it means that at precisely the moment when you want your bond to be bond-like it morphs into something else.

Imagine you are sky-diving, having a great time and enjoying the thrill of the fall. But as you plummet closer to the earth, you go to pull the chord on your parachute, only to discover it has turned into one of those squirrel suits. Suddenly, you are frantic: you really don’t want a squirrel suit right now, thank you very much; you would like your parachute! This is how we expect many junior bondholders of Banco Popular felt when they realized that the bank was going under and there would be a trigger event. At precisely the moment when they wanted to be a debtholder, they became equity holders and their capital got wiped out.

These bonds go by a number of acronyms. In Canada, the most common label is NVCC or “non-viability contingent capital”. However, the label (there are a few) is less important than recognizing its salient feature: it becomes equity in a crisis. And what constitutes a crisis is not up to you; it is up to the regulators.

How do regulators define a trigger event? In Canada, there are two conditions that could trigger a conversion into equity. The first is if the bank is deemed nonviable by the regulator (OFSI). The second is if the bank requires a bailout with public funds. Clearly the challenge with the first condition is that “nonviable” is rather vague. If you are worried about a potential bankruptcy scenario where you would lose part or all of your capital with a bond, you would hope that at the very least it would be well defined. Unfortunately this is not the case.

So why would an investor ever elect to own this kind of bond? Simple. These bonds typically offer a higher yield (more return potential) than the more senior bonds in a company’s debt structure. For this reason, an investor might decide that the additional risk is worth it. For example, if you believed strongly that a bank would never fail, it could make sense to own these kinds of bonds.

There are two challenges with this point. The first is that we suspect many investors fail to understand the risk they are taking when they purchase these bonds. It often takes reading the individual term sheet/indenture (something plenty of investors skip) to discover that the bond could turn into equity in a trigger event. The second challenge is one of sufficient return. To date, our team does not own any NVCC eligible securities. Simply put, we have not found the incremental return these securities offer appealing enough to overcome the additional risks we perceive in their structure.

Of course, there is a reason why regulators have supported the emergence of this kind of bond. NVCC bonds were created to ensure that investors, and not taxpayers, pay the price when a systemic bank is about to go under. Indeed, when Popular collapsed, the structure worked pretty much the way that regulators had hoped it would: investors were the ones on the hook. Many argue this is an improved set-up to guard against moral hazard. We don’t disagree. We simply think investors must understand what risks they are exposing themselves to should they purchase these bonds.

At present, there are around $16 billion of these securities outstanding in Canada, about 4% of the corporate bond market. That figure is growing but still small. Clearly, this is not yet a systemic challenge for the Canadian bond market.

Nonetheless, bond investors should be aware of what exactly they are buying. The structure of these bonds is, frankly, a bit sneaky. You don’t want to find yourself skydiving with a squirrel suit.