Unlocking extra income in subordinated financial bonds

How would you describe the subordinated financial bond strategy in a few words?

The subordinated financial bond strategy is actively managed and invests mainly in subordinated bonds issued by banks and insurance companies. In practice, it focuses on instruments – namely Additional Tier 1 (AT1)[2], Restricted Tier 1 (RT1)[3] and Tier 2[4] – that rank below the senior instruments within the capital structure.

Investors in subordinated financial bonds would typically be repaid after more senior bonds, should an issuer run into severe financial difficulty. As a result, they are compensated with a potentially higher level of income. Other specific features include potential skipped coupons and potential conversion into equity (or write-down).

Though the strategy invests in the lower range of the capital structure, we focus on investment grade issuers, which allows for a certain level of liquidity and diversification to navigate different market conditions over time.

Why focus on subordinated financial bonds?

Banks and insurers play a central role in the economy and are subject to strict regulation and supervision. Over the years, they have been required to hold more capital, improve their balance sheets and strengthen their risk management. This reinforcement of financial institutions’ capital structures is good news for bond investors, as it offers a higher quality issuer universe and a more predictable supply than in the period before the 2007–2008 subprime crisis.

Investing in subordinated bonds from investment grade financial issuers offers an additional layer of diversification, capturing yields that can be comparable to euro high yield bonds[5], but typically with stronger fundamentals. Regulatory capital requirements oblige issuers to maintain specific capital structure levels, which in turn lead to a well-telegraphed supply of subordinated bonds.

How do you manage the risks in this segment?

Risk management is at the heart of our approach. We look at the broader environment around financial issuers, which impacts their subordinated bonds issuance, including - but not limited to -  regulation, monetary policy, and M&A activity. We thoroughly analyse each issuer in detail: the business model, profitability, capital and liquidity. We only invest in institutions that we believe are robust and able to withstand stress.

We also look very carefully at the features of each instrument: when it can be called or redeemed, how and when coupons can be cancelled, what would happen in an extreme scenario, and where exactly it sits in the capital structure. We avoid structures that we consider overly complex or where the balance between risk and potential return is not attractive.

The portfolio is built around a core allocation to benchmark[6] issuers and a smaller diversification bucket in off-benchmark names and instruments. This allows us to add ideas from the wider global credit universe while keeping strict internal limits on issuers, sectors and liquidity.

On top of instrument selection, we also use simple overlay strategies[7] with listed interest-rate and credit derivatives[8]. These tools help us adjust the portfolio’s overall sensitivity to markets, manage volatility and seek to limit drawdowns when conditions become more stressful. Alongside our own controls, an independent risk management team monitors exposures and internal limits on a daily basis.

What are your strengths in managing this strategy?

Our core strength lies in the combination of specialisation in financials credit analysis, domain-specific expertise and a disciplined, risk-focused approach to subordinated securities. Our team has built long experience in analysing financial institutions’ capital structures, across different market environments and regulatory developments. This analysis goes beyond traditional senior credit assessment as it requires expertise in regulatory capital regimes, trigger events, loss absorption features and issuer behaviour under stress.

As part of a wider fixed income platform of around 40 specialists, we benefit from an average experience of more than 15 years in the asset class, and we harness broad credit insights while maintaining a focused cohort dedicated to financial issuers and the different segments of their capital structure. This enables nuanced valuation, issue selection and risk monitoring.

ESG is fully integrated into our credit analysis as a fundamental component of issuer risk assessment (for example, governance, risk culture). So far, our expertise has led to zero defaults in the strategy, which illustrates the strength and discipline of our process. Of course, this is an observation of the past and does not guarantee similar outcomes in the future, but it underlines the importance we place on careful issuer selection.

Finally, our co-managers structure provides the opportunity to challenge each other’s views and allows for consistency in the process. It ensures diversified viewpoints and robust decision-making in complex markets, helping to balance yield opportunities with structural and credit risks over time.

What makes your approach different?

Our approach is differentiated by the way we manage the asymmetric risk profile in subordinated financial bond, where instruments can offer interesting income but also embed non-linear downside risks.

First, we deliberately invest in relatively conservative issuers. Although subordinated instruments offer higher yield by nature, yield maximisation is not the only objective.  We focus on strong issuers, with robust capitalisation, disciplined balance-sheet management and business model that can absorb stress. In practice, this means we are dedicated to investing in names for which we have a strong conviction, and in our effort to identify risk-adjusted return in terms of instruments.

Second, we use the capital structure positioning as a risk-adjustment tool and actively allocate along the capital structure – between AT1, RT1 and Tier 2– and adjust exposure based on relative value, changes in market conditions, regulatory developments, and how likely it is that issuers will call and refinance their instruments (call incentives[9]). We seek to position the strategy where the balance between income, extension risk and loss-absorption risk is most interesting.

Finally, ESG factors are integrated as part of forward-looking risk analysis. For financial institutions, ESG factors such as but not limited to governance and risk culture are closely linked to credit quality. Integrating these elements into issuer assessment helps identify potential weaknesses as early as possible and supports more resilient portfolio over time.

Overall, our approach seeks to capture the structural income premium offered by subordinated financial bonds while maintaining a disciplined framework focused on downside control and consistency across market environments.