Subordinated debt is poised to make a comeback.
Debt issuance has at times been a popular option for banks because the interest payments are tax-deductible and it doesn’t dilute existing shareholders. But interest in subordinated debt fell out of favor last year as bank stocks spiked after the 2016 presidential election.
An erratic stock market is giving banks a reason to revisit debt as a way to fund acquisitions and other expansion plans, industry experts said.
“We're seeing the development in capital markets where they are more volatile and a wave of equity issuance has been done,” said Robert McDonough, a senior research manager at Angel Oak Capital Advisors, an investment management firm. “We think there will be substantial sub debt this year as there is a huge incentive for banks to consolidate.”
The amount of subordinated debt held by banks declined by 31% between 2013 and 2017, totaling $69 billion at Dec. 31, according to data from the Federal Deposit Insurance Corp. Last year, sub debt issuance at banks with assets of less than $30 billion fell by roughly 24% from the prior year, according to data compiled by Angel Oak.
Much of that dip could be tied to the stock market.
The KBW Nasdaq bank stock index has increased by about 47% since November 2016. However, the index has remained relatively flat this year, with a number of wild fluctuations that could make equity offering less appealing.
Subordinated debt and common stock issuance at banks with less than $100 billion in assets have been evenly divided through mid-April, with each totaling $900 million, said Edward Losty, a managing director at D.A. Davidson.
Investors are open to subordinated debt due to attractive yields, Losty said. Banks, typically viewed as solid performers, could also been keen on issuing debt while interest rates remain relatively low.
“Sub debt is certainly attractive and the market is currently open to it,” Losty said.
Debt deals typically come together more quickly than stock offerings, said Richard Schaberg, head of the U.S. financial institutions practice group at Hogan Lovells. As a result, banks can more efficiently raise small amounts through sub debt than they would through a stock offering.
Subordinated debt could prove to be a useful way of funding acquisitions, McDonough said. Many deals involve cash and stock, and the buyer might look at sub debt to cover the cash component.
Simmons First National in Pine Bluff, Ark., raised $330 million earlier this year by issuing subordinated debt, earmarking two-thirds of the proceeds to refinance senior debt and trust preferred securities, said Chief Financial Officer Robert Fehlman. The remaining funds could be used for acquisitions, though there are no immediate plans to do so, he added.
Simmons viewed subordinated debt as a relatively cheap way to strengthen its Tier 2 capital ratio, which had fallen after the $15 billion-asset company spent more than $150 million in cash for two acquisitions last year. While the company's 11.3% total risk-based capital remained above regulatory guidelines, management wanted to be conservative by increasing the ratio to about 13.5%, Fehlman said.
Interest from investors, which included insurers and other banks, was strong, Fehlman said. It was unclear to Fehlman whether more banks would consider sub debt since it depends on an individual institution’s capital needs.
“It all depends on the financial institution and their capital structure,” Fehlman added. “It costs more to raise common equity and it is going to be dilutive — but if you need common you will do it.”
Subordinated debt could also help banks address concentrations in areas such as commercial real estate, Schaberg said. While permissible, banks with CRE loans to total risk-based capital exceeding 300% are subject to heightened regulatory scrutiny. Additional capital is one way to lower that number.
Banks could also issue debt to plug holes that open up after the Financial Accounting Standards Board’s Current Expected Credit Loss Standard — or CECL — kicks in, said Joshua Siegel, CEO of StoneCastle Financial, an investment firm focused on community banks.
The new standard, set to go into effect in 2020, will require banks to assess potential losses over the life of the loan at the time it is originated, as opposed to when a loss seems likely. That adjustment could cause hundreds of banks to go from being well capitalized to critically undercapitalized, creating a need for up to $40 billion in capital, Siegel said.
“Sub debt will increase in demand,” Siegel said. “Why would you raise common dilutive equity? But I also don’t think there is a war chest of $40 billion in equity for private community bank investments. If you don’t act early, you may be late and the cost of that capital could be exorbitant.”