Subordinate Bank Debt Issuance on the Rise

In recent months several large and very stable banks, including Wells Fargo and U.S. Bank, have issued riskier bonds. These “subordinated” bonds trade at a spread above typically-issued “senior” bonds. For example, the Wells Fargo 2/13/2023 subordinated bonds currently yield 3.6%, compared to the Wells Fargo 3/8/2022 senior bonds, which yield 3.1%. Issuing subordinated debt translates into a higher interest rate expense for Wells Fargo, so why would they issue more of it? Wells Fargo is preparing for regulatory changes. The Third Basel Accord (B3) imposes capital adequacy, stress testing and liquidity standards on banks around the world. Banks like Wells Fargo expect U.S. regulators to augment B3 and require them to hold a certain amount of subordinated debt (guesses are 0% to 5% of “risk-weighted assets”) to combat the “Too Big to Fail” phenomenon via what the FDIC calls the Orderly Liquidation Authority (OLA). By forcing banks to issue a certain amount of subordinated debt, regulators hope to limit the downside risk to senior debt-holders. When a bank defaults, research shows subsequent losses are rarely as bad as the market expects. In other words, senior bonds are irrationally devalued, which prompts regulators to bail out senior bondholders. Regulators instead want to limit losses to subordinated bondholders, implicitly protecting senior bondholders. Banks are taking steps to meet the expected augmentation of B3 by refinancing senior bonds into subordinated bonds. Our expectation is that less senior bonds outstanding is good for senior bonds, while more subordinated bonds outstanding is bad for subordinated bonds, all else equal. Augmentation of B3 may take months (or years) to manifest, but when deciding between subordinated bonds offering higher yields and senior bonds, our current preference is senior bonds because they stand to decrease in supply.