Bank regulation could have negative effects for bond investors, it is claimed

A leading investment house is warning that although recent regulatory changes are intended to make the banking sector more resilient to future shocks there are possible negative consequences for bond investors, and indeed for the global economy, of these complex and far reaching alterations.

In the latest edition of Global Perspective, global fund manager Standard Life Investments agrees that the new regulatory approach should ensure a safer banking system, for individual countries and globally.

However, it outlines some major potential implications for investors to take into account, such as higher bank funding costs, lower profitability within the sector and a reduction in the investor base for banks to raise capital and funding.

‘The regulation of the banking sector is evolving rapidly, through national and cross border rule changes. Many issues are still to be determined. The implications of future discussions will be important, not only for bank profitability and for the holders of bank debt but also for economic activity as the cost of capital looks set to rise,’ said Andrew Fraser, Investment Director, Fixed Interest, Standard Life Investments.

'The most important issue for bond investors is that if banks fail, future losses will henceforth be spread across the capital structure. As regulation develops we think that it is likely to mean that spreads on bank bonds will trade at wider levels relative to history. Additionally volatility in spreads will be persistent implying investors require a higher risk premium for holding the asset class,’ he explained.

He pointed out that the new regulation has been put in place to reduce the risk that the taxpayer will again be required to bail-out troubled financial institutions. The Basel III proposals require individual banks to hold even more capital and liquidity and these will have to be of higher quality.

‘But the new terms and conditions may be off putting for some institutional investors. As well as having to adjust to a new regulatory era in which bondholders may have to absorb losses in failing banks, investors also need to understand the complex structures in the next generation of securities issued by banks,’ he said.

'For example, in order to count as Tier 1, bonds will need to have optional and mandatory coupon deferral language and have specific write down or equity conversion language on breach of certain triggers. If bond investors are not comfortable with these new terms and conditions, funding from institutional investors could be more difficult to obtain,’ Fraser explained.

‘This is an important issue for both bond investors and banks. The market for bank debt is substantial at $3 trillion or 44% of the total market and the ongoing need for financing the banking sector could be of the order of $1 trillion in the coming year,’ he added.