Issues : Strategy

Window of Opportunity for Sub Debt

Bankers who have not done so recently may want to revisit their subordinated debt playbooks so they can successfully navigate an emerging window of opportunity.

Market activity is up significantly due to interest rate trends, regulatory developments and other factors. Bank management teams who are prepared to act quickly can capitalize on the opportunity.

Sub debt is a long-term debt obligation with a maturity typically ranging from 10 to 15 years, a fixed (or fixed-to-floating) interest rate and the ability for the issuer to redeem the notes under certain circumstances. It has become a staple of bank capital planning, because it can qualify as Tier 2 capital if properly structured. Most banks can even use it to generate Tier 1 capital at the bank level, a strategy even more banks can employ following the 2018 changes to the Federal Reserve’s Small Bank Holding Company Policy Statement.

However, executives must be mindful of certain limitations of sub debt. In particular, its treatment as Tier 2 capital is phased out by 20% per year, beginning five years before maturity. Additionally, the interest rate typically flips from a fixed rate to a floating rate during the last five years, which is often higher than the fixed rate. Accordingly, banks that issued sub debt in 2014 and 2015 — when they were preparing for Basel III capital rules and, in some cases, repaying comparatively expensive Troubled Asset Relief Program funding — may now have the opportunity to refinance that sub debt.

New Issuances
Banks considering a new sub debt offering need to consider several matters in planning the transaction. These include many familiar decision points, such as selecting a placement agent or underwriter, deciding whether to seek a credit rating, consulting with regulators and determining the proposed offering terms, including offering size, maturity, interest rate structure, use of proceeds and other matters. In addition, banks will need to be mindful of federal securities laws that govern the offering.

There are also new issues for management teams to consider, like selecting a benchmark rate for the floating rate component. Historically, sub debt floating rates have been calculated based on the London Interbank Offered Rate, or LIBOR. Given LIBOR’s likely disappearance after 2021, issuers will need to evaluate whether to preserve the flexibility to select an alternate benchmark rate at the beginning of the floating rate period or to preemptively commit to an alternate benchmark.

Directors will want to make sure they have a clear understanding of how the offering complies with the company’s long-term capital plan and review the pro forma effects of the offering on capital ratios. From a fiduciary perspective, they also need to understand how the sub debt fits into the capital structure and how the organization will use the proceeds.

Given the significant planning needed ahead of a sub debt issuance, banks should begin the process at least two to three months before they need the capital.

Redeeming Existing Sub Debt
The mechanics of redeeming existing sub debt are relatively straightforward, and are governed by the terms of the notes and any applicable indenture. The terms can limit the dates on which a redemption can be completed, require some notice period to holders and dictate that partial redemptions be allocated pro rata among noteholders.

But before taking any steps, it is critical that issuers consult with their regulators and be mindful of related issues, including compliance with the Federal Reserve’s SR letter 09-4, which prescribes certain actions and considerations in connection with return of capital transactions. Depending on an institution’s size and other characteristics, it may need to obtain prior regulatory approval. Directors will need to understand the effects of the redemption on the organization’s capital structure and pro forma capital ratios.

Public Company Considerations
Banks with publicly listed holding companies will also want to evaluate whether to conduct a public offering through their shelf registration statement. This generally requires an indenture, clearinghouse eligibility, prospectus supplements, a free writing prospectus, limitations on credit rating disclosure and other actions. However, it can improve execution by making it easier for purchasers to resell their notes. Public companies also need to comply with their Exchange Act reporting obligations.

While there are several other issues to be considered in connection with any sub debt issuance or redemption transaction, management teams and boards of directors who have a basic understanding of the considerations outlined above will be well positioned to develop and maintain a strong capital foundation to execute their strategic growth initiatives.