By Konstantin Vasilev Member of the Board of Directors of Cbonds, Ph.D. in Economics
Updated August 06, 2023
What are senior non-preferred bonds?
Senior Non-Preferred Bonds, also known as Tier 3 Capital, are a type of debt securities available to banks. These bonds have specific characteristics and features designed to address potential financial risks and enhance stability within the banking sector.
These bonds are equipped with an intrinsic "bail-in" procedure, meaning that if the issuing bank faces the possibility of bankruptcy, creditors holding these bonds may be subject to conversion into shares. If the value of these shares increases over time, the bondholders can recover their invested capital.
Furthermore, Senior Non-Preferred Bond is governed by the MREL (Minimum Requirements for Own Funds and Eligible Liabilities) or TLAC (Total Loss-Absorbing Capacity) rules. These regulations establish minimum requirements for the amount of loss-absorbing capital a bank must hold to protect against potential losses.
These bonds can be issued as either traditional bonds or certificates of deposit. The principal amount and accrued interest of Senior Non-Preferred Bonds are generally known in advance, except in the case of specific types like Indexed Bonds or those with a floating coupon rate.
The maturity period for these bonds must be at least one year. As direct, unconditional, senior, and unsecured obligations, Senior Non-Preferred Notes are considered to have a higher ranking in the event of default compared to subordinated debt instruments.
Banks need to comply with EU legislation and ensure appropriate documentation on these debt instruments. The documentation must clearly indicate the rank of Senior Non-Preferred Bonds within the banks capital structure to provide transparency and clarity to investors and regulators.
An example of a Senior Non-Preferred Bond: BNP Paribas, 0.5% 30may2028, EUR
What is the purpose of issuing non-preferred bonds?
Non-preferred bonds, also known as Senior Non-Preferred bonds, are a type of senior debt issued by banks to raise capital. These bonds belong to a new category of debt securities introduced by the Financial Stability Board (FSB) to address concerns about the resilience of global systemically important banks (G-SIBs).
The FSB mandated that G-SIBs must issue a certain percentage of their risk-weighted assets in the form of non-preferred bonds. These bonds are designed to absorb losses in times of financial stress, and they are part of the resolution strategy to protect taxpayers from bearing the burden of bank failures.
Non-preferred bonds are distinct from traditional senior debt as they impose specific restrictions on them. Holdco bonds, a type of senior bond issued by the banks holding company, also fall under this new category.
Institutional investors, including central banks, play a crucial role in the demand for these bonds due to their focus on capital preservation and risk management. These investors are attracted to the higher yields offered by non-preferred bonds, which helps banks diversify their sources of funding.
By issuing non-preferred bonds, most banks can comply with the regulatory requirements set by the financial authorities and enhance their balance sheets stability. The goal is for these bonds to absorb losses and support the resolution process without the need for government bailouts.
The issuance of non-preferred bonds has strengthened financial systems worldwide, ensuring that G-SIBs can effectively manage risks and maintain stability. In the UK, as in other countries, the introduction of this new debt category has marked a significant step towards achieving financial resilience and protecting taxpayers from the adverse consequences of bank failures.
Security types of corporate bonds: Overview
Secured Corporate Bonds. In the ranking structure of secured corporate bonds, priority is given to senior "secured" debt, backed by collateral provided by the issuer. This contrasts with structures where debt age determines seniority. If a bond is classified as secured, it is supported by assets like industrial equipment, a warehouse, or a factory, making it more secure and likely to have a higher recovery rate in case of company default.
Senior Secured Bonds. Within this structure, any security labeled "senior" takes precedence over other sources of capital for the company. The most-senior security holders receive the first payout in the event of default, followed by those with the second-highest seniority, and so on until the available assets are exhausted.
Senior Unsecured Bonds. Senior unsecured corporate bonds are similar to senior secured bonds, except they lack specific collateral. Despite this, senior bondholders enjoy a privileged position in the payout order during a default.
Junior, Subordinated Bonds. After the senior securities are paid out, junior, unsecured debt is next in line for payout from the remaining assets. These bonds, also known as debentures, rely solely on the issuers credit rating and reputation as security. They are paid out after senior bonds in case of default.
Guaranteed and Insured Bonds. Guaranteed and insured bonds receive protection from a third party in the event of default, not collateral. For example, municipal bonds may be backed by a government entity or corporate bonds by a group entity. While they offer a second level of security with the credit rating of both entities, the level of security is limited to the second entitys credit rating. Thus, these bonds are less risky than non-insured ones and typically carry a lower interest rate.
Convertible Bonds. Convertible bonds are offered by some corporate issuers, allowing bondholders to convert them into common stock shares of the same issuer at a predetermined price, regardless of the stocks current market price. The price of convertible bonds is influenced by the companys stock price and prospects at the time of issuance, and they usually offer lower yields compared to standard bonds of similar size due to the expanded options they provide investors
What are preferred bonds?
Preferred bonds are a type of debt securities available to banks, specifically under Senior Preferred bonds. These bonds were introduced following amendments to section 46f of the German Banking Law on July 21, 2018.
In the unsecured bond market, there are two main categories: Senior Non-Preferred bonds, which come with a built-in "bail-in" procedure, and senior-level preferred bonds, which do not have this provision.
Here are some key characteristics of Senior Preferred bonds:
Principal Amount and Interest Rates. These bonds principal amounts and interest rates are known in advance, except in cases where there is indexation or a floating rate.
Repayment Period. Senior Preferred bonds have a minimum repayment period of at least one year.
Higher Rating. Generally, preferred bonds rating is higher than non-preferred bonds. This higher rating reflects their seniority and perceived lower risk compared to other bond types.
Direct and Unconditional Obligations. Senior Preferred notes represent direct, unconditional, and unsecured obligations, indicating that they are not backed by specific collateral.
Senior Preferred bonds are considered a higher-ranking form of debt within the unsecured bond market. They offer investors a level of security and priority in case of financial distress or bankruptcy of the issuing entity.
Non-preferred bonds vs. Preferred bonds
Ranking in Liquidation/Bankruptcy
Senior Non-Preferred Bonds. In case of liquidation or bankruptcy of a company, Senior Non-Preferred Bond is ranked higher than Subordinated Bonds but remains inferior to Senior Preferred Bonds or Senior Unsecured Debt. This means that Senior Non-Preferred Bondholders have a higher priority for receiving payments from the companys remaining assets than Subordinated Bondholders but are still lower in the hierarchy than Preferred Bondholders.
Preferred Bonds. Preferred Bonds are senior to both Senior Non-Preferred Bonds and Subordinated Bonds in the event of liquidation or bankruptcy. They have a higher priority for receiving payments from the companys remaining assets compared to both these other types of bonds.
"Bail-In" Procedure.
Senior Non-Preferred Bonds. These bonds come with an intrinsic "bail-in" procedure. If the issuing company is on the verge of bankruptcy, creditors holding Senior Non-Preferred Bonds may be subject to a conversion of their bonds into shares. If the value of these shares rises over time, the bondholders have the opportunity to recover their invested capital.
Preferred Bonds. Preferred Bonds do not have a built-in "bail-in" procedure. Their terms and conditions do not include automatic conversion into shares in case of financial distress.
Regulatory Treatment.
Senior Non-Preferred Bonds. These bonds are subject to the rules of MREL (Minimum Requirements for Own Funds and Eligible Liabilities) or TLAC (Total Loss-Absorbing Capacity). These regulations set minimum requirements for the amount of loss-absorbing capital a bank must hold to protect against potential losses.
Preferred Bonds. Preferred Bonds are not subject to MREL or TLAC rules. Their regulatory treatment may differ as they are senior to Senior Non-Preferred Bonds.
