2015 is set to become the third year in a row that total capital raised among U.S. banks has increased—on track for more than $140 billion issued by year-end. The recent boon in capital raising activity generally is attributed to the simultaneous increase in public bank stock values. The effect of market values on the decision to raise capital should not be discounted; however, capital demand has continued despite the market’s recent volatility and perceived weakness. Why has this trend continued?
The confluence of three factors, in particular, within the banking industry have helped fuel capital demand and have shifted demand for different forms of capital, including an increased demand for subordinated debt. First, the interest rate on Troubled Asset Relief Program funding has increased to 9 percent for most banks that still hold TARP funds. Second, participants in the Small Business Lending Fund have experienced—or will soon experience—an interest rate hike on those funds to 9 percent or more. Third, banks that deferred interest payments on trust preferred securities in the wake of the financial crisis must determine how to repay the deferred interest after five years or risk default. Each of these factors is prompting banks to consider capital alternatives.
The Rise of Subordinated Debt
Subordinated debt has become the darling form of capital for community banks (i.e., those banks less than $10 billion in assets). Thus far in 2015, subordinated debt has comprised 30 percent of all capital raised by community banks—up from 24 percent in 2014 and 7 percent in 2013. Why has this form of capital become so popular?
In simple terms, banks facing rate hikes on TARP, SBLF, and/or repayment of trust preferred securities have taken advantage of the low interest rate environment to raise capital on more favorable terms. Furthermore, the interest expense paid on subordinated debt is tax-deductible and it generally qualifies as Tier 2 capital on a holding company consolidated basis. In other words, newly issued sub debt can enable banks to reduce debt service requirements, increase regulatory capital, and preserve current ownership interests that otherwise could be diluted by raising common equity.
And as banks have become more creditworthy and investors have raised funds dedicated to community bank sub debt investments, the interest rate on sub debt has steadily declined: the median coupon for sub debt issuances in 2015 is approximately 5.25 percent, down from 7 percent in 2011.
You’ve Decided to Issue Sub Debt…Now What?
The process of issuing sub debt for most banks is straightforward. Investment bankers generally know investors with an appetite for sub debt and can provide banks with preliminary term sheets relatively quickly. For banks with more than $1 billion in assets, it could make sense to obtain a bond rating from a rating agency; the process generally takes four to six weeks and can be a great marketing tool when raising capital. A solid rating helps banks achieve better terms and opens the door to new potential investors, such as insurance companies, plus it gives investors added comfort in their own assessment of the deal.
Investor demand for sub debt will continue to increase as long as interest rates remain low and bank balance sheets remain strong. Banks considering a future capital raise should understand the benefits of sub debt and seriously consider it while the market is ripe.