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Senior TLAC bonds: the background

After the 2007-09 global financial crisis, the G20 adopted various measures to address the problem of financial institutions that are too big to fail – otherwise known as global systemically important banks, or G-SIBs. A G-SIB becoming insolvent would probably lead to significant damage to the economy and the financial system, so it was in everyone’s interest for any financial difficulties to be resolved in an orderly manner.

To avoid using public funds to bail out these banks like during the global financial crisis, regulators introduced the concept of TLAC-eligible liabilities that could be used to “bail in” a bank in financial difficulty. Bailing in would involve the debts owed to the holders of these liabilities being cancelled or converted into equities when a trigger event occurs.

The G-SIB banks are required to hold TLAC liabilities equivalent to a minimum of 18–20% of their risk-weighted assets. They can be in the form of – in order of descending risk – common equity, additional tier 1 bonds (AT1s, and also called contingent convertibles or cocos), tier 2 subordinated debt and senior TLAC bonds (it is this last category that we are focusing on in this article). All provide investors with less protection than TLAC-excluded liabilities, such as a bank’s deposits and structured products.

How the various TLAC-eligible debt securities compare

AT1s and tier 2 debt incorporate strict loss absorption language that states they either have to be written off or converted into common equity whenever a trigger event occurs. A trigger for an AT1 would be when its common equity tier 1 ratio (the ratio of a bank’s liquid holdings, such as cash and stock, to its assets) falls below a certain level. Tier 2 subordinated debt is next in the firing line if the regulator decides that the bank is still non-viable even after its equities and AT1 bonds have absorbed losses.

Senior TLAC bonds, by contrast, do not incorporate such loss absorption language. In practice, this means that their holders are only at risk in an extreme scenario in which a bank faces huge losses and is unviable even after the rest of its regulatory capital has been wiped out. That said, as they are TLAC-eligible securities, they still rank behind the bank’s senior debt. In practice, TLAC bonds could be considered similar to standard corporate bonds – investors in which accept the risk of incurring losses if the issuer faces extreme financial distress.

Other factors to consider are that banks can skip coupon payments on their AT1 bonds without any penalty, and that these bonds are perpetual – they have no fixed maturity date. Subordinated tier 2 and senior TLAC bonds, by contrast, cannot skip coupon payments and mature at a set date. Meanwhile, senior TLAC bonds must have at least a year of residual maturity to be considered TLAC-eligible, and as such are often called by the issuing bank when they lose their TLAC-eligibility a year prior to maturing.

Senior TLAC bonds are not all alike

Senior TLAC bonds are subordinate to a bank’s senior debt, but that subordination can be achieved in different ways.

First is structural subordination, which involves the issuance of long-term unsecured debt at the parent level, where the parent is a non-operating holding company. This format is often used in the US, UK, Switzerland and Japan.

The second is contractual subordination, which is achieved by the creation of a third tier of debt, known as senior non-preferred, which will absorb losses after junior debt but before any other liability. This approach is commonly used by French and Spanish banks.

The final method is statutory subordination, which is achieved by creating a different hierarchy of claims in the resolution regime. This method is adopted in Germany.

What to consider when investing in senior TLAC bonds

Senior TLAC bonds can make attractive investments: because they are lower down the capital structure they provide a higher yield than senior bonds from the same bank, but they are more secure investments than its AT1 and subordinated tier 2 bonds. That said, they can be volatile instruments, particularly if the macroeconomic backdrop deteriorates and it looks likely that a bank will experience financial distress.

Before investing in senior TLAC bonds it’s important to consider factors including the issuing bank’s current CET1 ratio, its capital structure and the quality of its loan book; the outlook for the economy and interest rates; and whether the yield provided by the bond provides adequate compensation based on this analysis.

It’s also important to think about whether the bond is likely to be called a year prior to maturity, and the implications for its price if it is not called and it loses its TLAC-eligibility. So far there have only been a few instances of bonds not being called, but non-call may become more common now we are in a higher-interest-rate environment and it makes more economic sense for banks not to call.