Before investing in subordinated bonds

The key reason is that the Bank of Thailand (BOT) allows funds raised from subordinated bonds whose maturity starts from 10 years to be treated as Tier 2 capital or supplementary capital, which would reduce operation risks and strengthen the financial status of commercial banks.

A subordinated bondholder will, however, be the last creditor to receive payment if the issuers go bankrupt. Such risk premiums therefore tend to make these bonds’ coupon rates higher than those of senior bonds. 

Apart from thoroughly reading the prospectus before investing in any given subordinated bond, investors should be aware of other risks, including:

Credit rating risk: A bond issuer’s credit rating may somehow be downgraded by the credit rating agency during the investment horizon. 

Liquidity risk: Most subordinated bonds are illiquid due to the long-term investment horizon.

Interest rate risk: Investors may lose their opportunities for higher returns from other investments if the market interest rate should increase during their investment.

Call risk: The issuer of subordinated bonds with an embedded call option may “call” or redeem the bond before maturity. Generally, the issuer calls the bond at par, when the market interest rate is lower than the bond’s coupon rate. If the bond is called, investors could find new investments in the market interest rate lower than previous investment in the subordinated bond. 

Inflation is also a key factor to be concerned about. Investing in long-term bonds under current market conditions, investors may face a rising inflation rate in the latter half of this year. Domestic consumption and government economic stimulus measures are key drivers of inflation. To name a few issues, inflation is sensitive to an increase in the minimum wage, fuel and gas prices, and government spending. It is thus highly unlikely to see any reduction in interest rates in the second half of this year. 

The BOT will be issuing new bonds to re-finance government savings bonds, which are due this year, with tremendous value.  Moreover, many private companies may raise capital by issuing bonds. Bond supply is therefore bound to increase. Investors would be better off if they purchased bonds to be issued next year with higher coupon rates. 

Subordinated bonds issued by financially solid commercial banks are suitable for passive investors who enjoy stable streams of cash flow and higher returns than current fixed deposit rates. These investors are satisfied with the bonds’ consistent returns and are likely to hold on to their bonds until maturity. 

On the other hand, active investors who adapt their investment strategies in line with market conditions should buy a minimum number of subordinated bonds. To achieve their investment objective of total return, I recommend allocating one’s portfolio into assorted assets. Short-term debt instruments and stocks would give investors higher returns amid the prevailing global economic recovery and rising local interest rates in the second half of this year or early next year. 

 

Ladawan Charoen-Rajapark is managing director of Asset Plus Fund Management.