It has been another active year in the community bank debt market.
In 2020, new issuance reached a high of $12 billion for banks with less than $50 billion in assets. It’s no surprise that 2021’s issuance was lower than a year prior, but it is certainly not low by historical standards: 2021’s issuance exceeded all years except for 2020. Unsurprisingly, the primary driver behind the activity has been low rates caused by the accommodative pandemic-driven monetary policy, leading to changes in investor behavior.
An Issuer’s Market
The prospect of issuing low coupon fixed-rate debt always attracts the attention of issuers. Accommodative monetary policy in response to the coronavirus pandemic has led to a low in the absolute rate level precisely at a time when many early subordinated debt issuers were at or close to the first call dates on their outstanding issues.
For most of April 2020, the new issue market was shut. As the market reopened that spring, rates were low, but spreads – at least initially – were not. The coupon spread on new issues during this period, unsurprisingly, more than doubled compared to pre-pandemic levels.
Throughout summer 2020, spreads declined to more historical levels and issuance increased. They now seem to have recently found a support level of approximately 200 basis points over the 10-year Treasury yield.
The accommodative monetary policy has caused a secondary effect: return deficiency. Low returns have affected all investors, resetting return expectations. Yields on Treasuries and mortgage-backed securities – typical investments in a securities portfolio of a bank – are still historically low and scarcely provide any real returns. Excluding the temporary effect of Paycheck Protection Program (PPP) loans, many banks are still experiencing low loan demand and need to buy securities to earn some yield.
Searching for Yield
The combination of low yields and low loan demand has nudged banks into buying new issue community bank subordinated debt. The rationale here is that subordinated debt provides excellent relative value: better yield than other investment-grade credit, from an issuer known and understood by other banks.
As banks became marginal buyers of new issue paper, they crowded out many of the well-known asset managers in the market. While still a major presence in the sector, asset managers have been increasingly selective in purchasing new issues, preferring the higher-yielding paper as opposed to lower yielding, plain vanilla-type issues. For their part, asset managers are applying their expertise in areas such as nonbank financial issuers, including fintech, oftentimes with underlying assets similar to banks.
The tertiary effect of these low rates is the seeming indifference of the market to any connection between coupon levels and issuer credit ratings. Pre-pandemic, there had been somewhat of a relationship between the two. Post-pandemic, it is not possible to draw any linear relationship. This benefits smaller, unrated bank issuers in a way that has no historical precedent.
For instance, in early November 2021, New York-based Amalgamated Financial Corp., which has $6.9 billion in assets and a BBB- subordinated debt rating from Kroll Bond Rating Agency, issued $85 million of 10-year subordinated notes (callable in 5 years) with a 3.25% fixed coupon.
Three weeks later, Michigan-based Arbor Bancorp, the unrated parent company of $2.7 billion Bank of Ann Arbor, issued $75 million in 10-year subordinated notes (also callable in 5 years), at a slightly lower rate of 3.125% and with a spread that was 9 basis points tighter to the 10-year Treasury yield. Such examples are becoming relatively commonplace.
The inflationary and rising rate environment is forcing asset managers to consider interest rate risk for the first time in years. Many banks classify subordinated debt as held for investment, but those that are considering selling may have to weigh a liquidity discount as rates rise.
In order to take advantage of current low rates, some banks over the past few years have issued subordinated debt as a means to pre-fund an existing issuance with an approaching call date. As rates remain low, expect that to continue. But as they rise, credit spreads could follow. Issuers who have not taken advantage of the market to date may want to push issuance to the first half of the year.