Introduction
Investors must be aware of where investments rank in the capital structure of a company to ensure that they are earning appropriate returns for their investment. Debt with higher risk should carry greater reward over lower risk or more senior instruments.
Investors understand the need to compare credit risk across alternative bonds, most commonly measured by the credit rating. Generally speaking the lower the credit rating, the higher the risk and thus the higher the required return. This is a concept that is generally well understood.
Extending the above concept, investors need to know where an investment ranks within an individual company's capital structure in a similar fashion. It is not uncommon for there to be six or so notches difference between the credit rating of a bank or insurance companies senior unsecured debt and the rating assigned to lower ranking Tier 1 instruments such as preference shares. Equity, which is never rated, is by default always the riskiest investment level in any given company.
Capital structure can be a complex issue, particularly for banks who must meet strict standards set by sovereign regulators. Further, while international guidelines are issued and banks often report under similar terms (for example Tier 1 capital) calculations vary by country.
Funding
Basically, there are two forms of funding; debt and equity. The main differences between debt and equity relate to risk and reward. From an investor s point of view ordinary shares are riskier than debt (due to greater volatility, uncertainty of dividends and lowest repayment ranking in the case of liquidation), however, the expected return through dividends and capital gains are likely to be higher over the long term but that is not always the case. From a company s point of view, the reverse is true. Debt is often cheaper than equity (partly because interest is tax deductible) but it also comes with greater risk due to the legal requirement for timely payment of interest and principal, versus equity which has no repayment date (i.e. is perpetual) and no legal requirement to pay dividends.
Decisions about funding are complex. Some structures are defensive and aim to limit the number of shareholders and the value of stock. Companies in several industries can sustain high levels of debt, for example food retailers, given very stable market conditions, while others involved in very cyclical industries may prefer lower debt levels and an overall higher level of equity. Banks and other financial institutions are subject to regulatory requirements which in themselves are extremely complex. Below is a very general discussion of capital structure.
Capital Structure
The diagram above describes the capital structure for a typical company. The various elements of the capital
structure are shown in order of;
(a) risk - ranging from senior debt as the least risky down to equities as the riskiest.
(b) priority of payment in the case of liquidation - with senior debt to be paid out in full first (with secured debt having first call on the specified security), then all subordinated debt, then all hybrid debt and if any funds remain equity holders share the balance.
(c) application of losses - with equities to bear the first loss and the security of senior debt holders investments only threatened once all other junior capital sources have been exhausted.
In accordance with risk, the expected long-term return should increase as you move down the capital structure.
It is important to note that companies often issue senior secured debt. This is generally the safest form of debt for an investor/financier as there is a direct claim on defined assets of the company (or the entire company itself) and could be considered at the top of the capital structure.
The most basic example of senior secured debt is a first ranking mortgage secured over property. However, security can be in the form of practically anything and with banks it is common that a certain debt can be secured or covered by a pool of loans. Senior secured debt holders have first ranking claim on the assets to which they have security over.
Taking this process one step further is securitisation which is often done off balance sheet whereby the investor has security over the assets (generally loans) in the securitisation structure (a special purpose vehicle) but does not have recourse to the arranger, generally a bank, in circumstances where the security is insufficient to pay their claims.
Bank capital structure is significantly more complicated, due to the complex and authoritative standards imposed by sovereign regulators such as the Australian Prudential Regulation Authority (APRA). Generally bank capital structure includes deposits, which depending on the country of origin can rank above debt, making them the least risky investment, as they are repaid first in the case of liquidation. Deposits rank above debt in the US and Australia and in Switzerland the first CHF100,000 is given priority to debt.
However, in most European countries deposits and senior debt rank equally. The inclusion of government guaranteed deposits and wholesale bonds obviously reduces the repayment risk to the investors and does act to change the order of repayment in a liquidation.
The complexity is found in the Tier 1 and Tier 2 capital instruments which have various terms and conditions. Their main purpose is to absorb losses should a bank enter financial difficulty and are designed to protect
senior debt holders and depositors. (See the appendices for an example of the capital structure of a typical Australian bank, together with a working example of the rating and return differential for two separate banks as you move down the capital structure).
Capital Structure Levels (from lowest risk to highest risk)
Senior Secured Debt
Senior secured debt is generally the lowest risk, first ranking debt instrument. It is more common in corporate
structures (generally with a bank taking security over certain assets) than in bank funding structures.
Deposits
For banking institutions, or Authorised Deposit-Taking Institutions (ADI) which is the official Australian name, deposits are generally the highest level in the capital structure. Technically speaking, senior secured debt can rank higher but in the main, banking institutions have little or no secured debt, depending on the domicile/regulation of the issuer. In Australia, deposits are always the most senior element of the capital structure. Deposits have always been low risk investments but that status was strengthened by the Federal Government s guarantee, which is free for deposits maturing before 11 October 2011 for amounts up to $1m.
This practically makes a guaranteed term deposit a risk free investment for a depositor to lose their money not only would the bank issuing the deposit have to go into liquidation but the AAA rated Australian government would then have to default on its guarantee.
If investors hold more than $1m in term deposits with a given ADI then the excess over that threshold is not subject to the government guarantee unless an additional premium of 70bp to 150bp is paid (depending on the rating of the accepting financial institution). Even if the funds aren t guaranteed, term deposits still represent a very low risk investment as they are afforded priority of payment before other forms of debt (other than secured debt) in a liquidation scenario. Term deposits typically represent about 50% of a major bank s funding although this percentage has increased in recent months as investors seek the safety of cash and the banks are offering more attractive rates in response to their own increased funding costs.
Debt
Companies can borrow from a bank or finance institution or they can sell bonds to other companies or individuals.
Benefits
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Generally, fixed income investments like bonds pay higher interest returns (or coupons) than cash
management or deposit accounts.
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Provide investors with a steady reliable income stream, whereas returns from shares vary according
to profitability.
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Bondholders are creditors of a company and their return is at a set rate (this can be fixed, at say 6%, or floating at say 3 month BBSW + a fixed margin) over the life of the bond, until it is repaid at maturity.
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Bondholders rank higher than shareholders in the case of liquidation and have a higher claim on the companies assets.
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Risk is lower than that of shareholders. The return, while defined, is expected to be lower than
shareholders over the long term but over shorter periods can exceed equity.
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Repayment is at a specific time (maturity) for a specific amount (face value).
After secured debt, senior debt takes priority over other debt securities sold by the issuer. If the issuer enters liquidation, senior debt must be repaid before subordinated creditors receive any payment. Senior debt ranks behind depositors in Australia. An issuer has no ability to defer coupon payment to senior or (lower tier 2) subordinated debt holders and generally speaking any missed payment of interest or principal is classed as an event of default.
Subordinated Debt (sub-debt) issues are very common in the banking industry and most have the same ten year non-call five year format. The main point to note is that in liquidation, subordinated debt is not paid until all senior debt and unsecured creditors are first paid. In many of the recent bank failures in the USA and Europe, it is expected that the subordinated debt holders will receive close to zero if not zero. However, if the bank does not enter into liquidation, then payment is on equal footing with all other creditors and debt holders as those debts fall due. It is generally only an issue if the bank encounters significant difficulty or enters liquidation.
The other important distinguishing feature of bank subordinated debt is that it is typically issued as a ten year legal maturity but callable after five years. This most common type of subordinated debt is lower Tier 2. In practically all cases in Australia, subordinated debt is called after five years. It is very unlikely, but possible, that subordinated debt may not be called if APRA determines that the bank in question has capital levels that are too low and is not allowed to call (or repay) the subordinated debt. A bank has the option not to call and redeem their subordinated debt on any call date, but must balance the reputational risks of not doing so as well as the economic cost of any increased coupon and the amortisation of the regulatory capital value over the remainder of the term. Deutsche Bank decided not to call a Euro denominated subordinated debt issue in December 2008 and have subsequently not called other denomination subordinated debt, including an A$ issue in early 2009. To date Deutsche Bank are the only major bank not to call at first opportunity.
Hybrid Securities
Hybrids, or income securities as they are commonly known, are a more retail investor orientated product.
When they were initially introduced many had equity upside attached to the securities hence the name hybrid a mix between debt and equity. However, most hybrids now issued don t offer equity upside and instead act like debt products.
There is more flexibility in the structure of hybrids compared with corporate bonds they can have many different features. Some carry franked distributions, others are perpetual and some offer upside (and downside) depending on the price of the underlying shares.
Hybrids can be attractive because they provide retail investors a chance to access a corporate bond style security offering higher returns than most other fixed income products. They are also liquid assets that are traded on the ASX although volumes traded have dropped off dramatically recently due to the global financial crisis.
Those features are countered by the fact that hybrids carry higher risk than all of the above mentioned debt securities as they sit below them in the capital structure. The other key difference between hybrids and the higher ranking senior and subordinated debt is that interest payments on hybrids can be deferred or in some cases completely missed. Also, hybrids are typically equity (preference shares) on company balance sheets and there is no legal requirement for them to be redeemed hence they are technically perpetual.
Equity
A company issues shares to investors, who then own a percentage of the company. Shareholders generally have the right to vote at annual meetings to appoint directors and on issues that affect the ongoing management of the company. Ordinary shares have no maturity and are held until the investor decides to sell via an exchange like the Australian Stock Exchange. A shareholder would expect to receive dividends, which are paid at the discretion of the board and at a level which is also dependant on board approval.
Benefits
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Share prices fluctuate according to supply and demand. A growing company, which can regularly improve profits and thus potential returns to its shareholders, is likely to see its share price rise.
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Holding shares can be advantageous to investors on high marginal tax rates. Some companies pay the tax on the dividends prior to paying them, giving the investor franking credits which can be offset against their own tax calculations.
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Normally very liquid investments that can be easily traded and realized.
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Allows high and unlimited returns if there is an increase in share price.
Disadvantages
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Lowest ranked investor in the case of liquidation. In a winding up, the legal existence of a company comes to an end. Ordinary shareholders will only receive a payment once all other creditors and preference shareholders have been paid in full. Usually a shareholder would not expect to recover any of their investment in the case of liquidation.
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Volatile markets may result in price volatility.
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In times of poor profitability, dividends may be reduced, or not paid at all, which will ultimately be
reflected in a lower share price.
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A company s decline may be very quick and to an off-guard investor fatal, in that they have no time to sell or dump their holding.