IN the context of persistent market volatility and investor uncertainty, we return to the basics. What makes an institution “safe”? Today we focus on financial entities, as their performance has a significant effect on overall market performance.

An important measure of stability and safety for a financial institution is the size of its capital base relative to its assets. In plain English, this is simply the amount of money which the shareholders have in the company relative to the value of the assets the company owns. The “amount of money which the shareholders have in the company” is comprised of the portion of profits it keeps (ie its retained earnings and reserves) as well as the funds that have been injected directly by shareholders (ie its share capital). There are many other accounting technicalities that allow institutions to classify other monies in their capital base. Generally, the capital base is what is left over after the liabilities are subtracted from the assets. This figure is very important for investors as it represents the institution’s ability to withstand fluctuations in the value of the assets in their portfolio. Essentially, the capital base acts as a cushion against potential losses that a financial institution may experience. Investors may therefore gauge the safety of their investments by looking at the relative size of the institution’s “capital cushion”.

The capital cushion or capital base of a financial institution is also important because of accounting rules. Most losses that an institution experiences are “written off” against (i.e. subtracted from) their capital base. In other words, the capital base acts as a buffer to absorb certain types of losses experienced by the institution. The importance of the relative size of an institution’s capital base is reflected in the new Basel III measures as well as the EFSM’s (European Financial Stability Mechanism) which require all banks to increase their capital ratios and improve the quality of its components. At present, certain types of bonds issued by financial institutions can form part of their capital base. These bonds can take on characteristics of both debt and equity and we’ll take a look at how these instruments work.

Bonds can vary in the level of repayment seniority in which they rank. This variation allows an investor to choose a point along the risk spectrum where they are most comfortable and enjoy the accompanying return. Bonds with very high levels of seniority are usually among the first in line to be repaid if the company goes bankrupt. These bonds generally attract relatively lower rates of return because of their priority in terms of repayment. Bonds with lower levels of seniority are referred to as “subordinated” debt. Further variations exist within the “subordinated debt” category but the principle remains the same as we move within the category: there are more entities in front of you who will be repaid first in the event of default. In most cases, subordinated debt is rarely collateralised and the bond is essentially backed by the full faith and creditworthiness of the institution or sovereign. For this reason, it is essential to choose institutions with a high credit quality when investing in these types of bonds.

Additional features are often applied to subordinated debt which leads to a new asset class which contains instruments referred to as “hybrids”. Hybrids are instruments that take on features of debt and equity. Some of these instruments are now treated as part of the financial institution’s capital base. A few weeks ago, the Sterling Report described perpetual notes, ie “Bonds with no fixed maturity date (or very long tenors eg a 50 year tenor). Since these bonds have no fixed maturity date, they are somewhat akin to equity. Under this premise (as well as others), regulators permitted them to be treated as such. These bonds are usually classified as “tier one capital” on a bank’s balance sheet.”

These bonds typically have embedded call options, fixed to floating interest rates and most importantly, they have specific covenants that govern the payment and accrual of interest and the classification of the bond. As previously stated by the Sterling Report, “since these bonds form part of an organisation’s capital base, most issuers stipulate that they can suspend or withhold interest under certain circumstances. These circumstances usually describe severe financial difficulty which threatens their ability to meet their minimum capital requirements. If an institution is in danger of breaching its minimum capital requirement, it can exercise its right to withhold an interest payment to these subordinated debt holders. Additionally, some institutions incorporate a covenant which permits them to convert your bond holdings to equity should the need arise. This need would arise under a similar set of circumstances as described previously.”

The important premise here is that investors do not have to compromise the creditworthiness of their investments in order to attain higher returns. These types of instruments allow an investor to preserve the high credit quality of their investments, by taking on other risks that do not threaten the principal of their investment.

Marian Ross is a business development officer at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles,

e-mail us at: info@sterlingasset.net.jm