Given the increasingly complexity and num­ber of fixed income assets available to retail investors, we thought it would be worth­while taking a step back and looking at the capital structure of a bank or company in greater detail. For anyone investing into hybrids or bonds understanding the corporate capital struc­ture is non-negotiable tool, as capital losses in a seemingly low risk investment can be es­pecially damaging. Therefore, it is important to explore in more depth and highlight the risks in the capital structure, to ensure that one is adequately compensated for taking a certain amount of risk. The capital structure influences the return for shareholders and whether a firm can survive events such as the Global Financial Crisis or other economic recessions.

A lot of fund managers talk about and reiter­ate balance sheet strength as a key determi­nant of a firm’s quality. There is a common dilemma with companies in whether they should return excess cash to sharehold­ers and finance their business with debt, given its tax effectiveness, or the opposite. The long-term impact of a business’ capital structure can determine its cashflows and weighted average cost of capital. The under­lying capital structure can even create intrin­sic value. Your concern here should be the financial health and long-term sustainability of a company.

Debt and Equity

There are two components to the capital structure, debt and equity. Each has its own benefits and drawbacks. Equity is money in­vested by shareholders who own the com­pany and are entitled to a share of future earnings and dividends. Generally, the cost of equity is higher as a firm must generate a return to attract shareholders, whether in the form of dividends or a higher share price. The Return on Equity is, in itself, a cost and equity alone can be worthless in the worst case scenario.

Debt involves a company borrowing money that they can use in the business, with the longer-term debt the lower risk. Debt is sim­ply an agreement to repay a certain amount of capital in addition to an agreed and fixed level of interest. The challenge for investors when under­standing this mix is we generally seek to pay down debt as quickly as possible and therefore can become averse to higher levels of debt. In contrast, for a company with an indefinite lifetime, can generally choose the lowest cost of capital i.e. debt or equity to fund their firm. If they can borrow money at 5% for 20 years and generate a return of 10%, it is a no-brainer to use debt to fund a large portion of their capital structure. A company’s capital structure allows inves­tors to draw some conclusions on how risky it is to invest in a certain business. Individ­uals must be cautious when companies are acquiring goodwill on their balance sheets, as intangibles can be written down and have a potentially negative effect on the equity component of the structure, which then af­fects the capitalisation amount.

Companies can often issue long term debt with bonds and long-term fixed maturities at low rates, but holders of these investments generally cannot demand payment in trou­bled times as long as the company pays the interest on its funded debt. This debt gives a company more breathing room. Howev­er, some would argue a higher percentage of debt to equity in the firm’s capital struc­ture means increased fixed ongoing obliga­tions. In a downturn this can mean less of an operating profit buffer and greater risk. Greater risk means higher financing costs to compensate lenders for that risk. Our focus in this article is on a company’s capital struc­ture and the hierarchy of all the claims that different parties have on a business. We have provided the capital structure illustration ABOVE/BELOW to highlight how the com­pany’s capital structure is assembled, from highest risk to lowest risk and where each investment ranks.

Lowest Risk, Lowest Return 

Senior secured debt or covered bonds are the lowest risk in the capital structure as they are the last asset to be applied with losses. It can be common in corporate structures where the bank takes security over certain types of assets. Senior means the debt ranks above all other obligations of the company and secured means the debt is secured over the physical assets of the business. Senior se­cured debt is typically only available via the institutional over the counter market, but the likes of FIIG are slowly increasing their offering in this space.

Term deposits are the next safest and high­est in a bank’s capital structure, as they are low risk investments. Term deposits are not secured by the assets of the company, rather the company itself and therefore represent slightly higher risk. They have, however, been strengthened by the Australian Feder­al Governments $250,000 deposit guarantee which applies per person per institution. Interestingly, term deposits can offer lower interest rates than secured debt due to the monopolistic control that the major banks have over the sector. Senior debt is the next rung down the struc­ture but is still relatively low risk given its priority of payment in liquidation. This debt is generally provided at low rates with less restrictive debt covenants and therefore results in lower interest repayments for a company. However, a company cannot de­fer these payments and if they were to miss a repayment they could trigger a default event. Senior debt is not secured by individ­ual assets of the company but ranks ahead of hybrids, equity and subordinated debt in the event of default. Subordinated debt e.g. Mezzanine Debt is further down the struc­ture and falls behind the previously stated liabilities in liquidation. We point out that in some bank defaults in Europe and North America, investors in these instruments re­ceived $0 or close to zero in the worst-case scenario. An example of this level in the cap­ital structure is WBCHB or Westpac Subordi­nated Debt II, which trades at $100.85 with a yield to first reset of 3.09% and gross run­ning yield of 4.00%. You will note the yield is higher than the term deposit highlighting the increased risk taken on but not as high as ordinary shares.

The second riskiest level of the capital struc­ture is hybrids, or converting preference shares. Hybrids are debt like in that you buy at face value and receive a coupon, but equity like in that they can convert to equi­ty at the bank’s discretion and are further down the capital structure. An example of this blend is Westpac Capital Notes WBCPD which trade at $102.18 and offer a running yield of 4.82%. Once again higher risk, slight­ly less liquidity in a default event, resulting in a higher return to investors. If you look at the terms of WBCPD you will see that these are:

  • Non-cumulative – missed distributions are not accumulated;
  • Convertible – they can be converted to equity at the discretion of Westpac;
  • Transferable –they can be sold to a sub­sidiary or Westpac;
  • Redeemable – they can be redeemed at par value of $100;
  • Subordinated – the fall below other is­sues and below subordinated and other debt of the bank;
  • Perpetual – they technically could con­tinue paying distributions forever;
  • Unsecured – they do not provide any charge of the assets of Westpac.

As you can see, the terms are quite broad and you can in fact see that hybrids like this may represent more equity risk than many investors expect. It is for this reason that its imperative investors receive a fair reward for the level of risk they are exposed to.Equity is the highest risk and potentially the highest returning component of the capital struc­ture. Westpac ordinary shares yield 5.9% and their ROE of 13.5% highlighting the risk and return trade-off, ensuring equity hold­ers are compensated for taking the most amount of risk in the capital structure. To further breakdown the equity component, preference shares are the higher ranking of the two. Common or ordinary equity is the most junior in the capital structure, with owners entitled only to assets after all obli­gations have been paid off. It is naturally the highest risk and highest potential yielding investment in the capital structure.

Examples

A recent global example which occurred in Venezuela highlighted risks associated with the capital structure. There was a lot of de­bate around whether a credit event had oc­curred with the state-owned oil and natural gas company who weren’t making payments on their debt, and whether the triggering of a default for bondholders had occurred. Peo­ple were expecting creditors to initiate a re­structure and even take a reduction or hair­cut in their entitlements but a deal with the government eventuated. There are all kinds of complexities if bondholders declare de­fault on the bonds, as cross-default clauses would likely trigger default across the capital structure. Apparently, the country has little reserves, would struggle to make payments and investors would be hit hard. Even the firm’s assets are miniscule compared with the $US120bn at stake.