Tutorial: Subordinated bonds

What are subordinated bonds?

Subordination means that the investor's claims of a subordinated bond will be settled only after all non-subordinated debt securities (such as covered bonds, non-subordinated / senior bonds) have been settled. If, therefore, the issuer should be liquidated, all non-subordinated debt would be fully paid out first and subordinated bonds would be settled thereafter. Due to this risk, the yield on subordinated bonds is higher than on non-subordinated bonds.

How do subordinated bonds work?

A subordinated bond is interesting for you if you want to achieve a higher return compared to non-subordinated bonds. The creditworthiness of the issuer is essential. Redemption is at 100% of the nominal amount if no early redemption due to legal or tax changes and no statutory loss participation obligation takes place beforehand. For early redemption, the redemption amount is also 100% of the nominal amount.

The loss-sharing obligation includes future measures by supervisory authorities to stabilize banks in a crisis situation. From today's perspective, the following measures are possible: reduction of the nominal amount of (subordinated) bonds; conversion of (subordinated) bonds into equity (e.g. shares); transfer of values to other companies. The loss-sharing obligation is part of the discussions of the regulators (EU, Republic of Austria, FMA, Basel Committee on Banking Supervision "Basel III") regarding the handling of banks which are insolvent or where insolvency is imminent. The regulatory changes are not exactly defined yet but may interfere with the rights and obligations of investors through the measures described above or even to a bigger extent. This risk is compensated with a higher interest rate than for non-subordinated bonds.

Your benefits

With a subordinated you may achieve higher returns through above-average interest income while investing your capital in a well-considered manner. Your investment horizon is medium to long term.

Your advantages

Due to the design of subordinated bonds, the potential risk is compensated with a higher interest rate than for senior bonds.
Redemption is at 100% of the nominal amount at the end of the term, provided that no early redemption due to legal or tax changes and no statutory loss participation obligation takes place beforehand.
Redemption is at 100% of the nominal amount even in the case of an early redemption due to legal or tax changes, provided that no statutory loss participation obligation takes place beforehand.

Risks you should be aware of

Redemption at 100 % of nominal amount only applies upon maturity. provided that no early redemption due to legal or tax changes or no statutory loss participation obligation takes place beforehand.
Changes of the interest rate and credit quality of the issuer may result in price fluctuations and capital losses when selling the bond before maturity.
There may be a potential statutory loss-sharing obligation for investors due to future legally binding regulations (not yet known at the time of issue).
In the event of insolvency of the issuer, the investor's claims will only be settled after all non-subordinated debt has been fully paid out.
Subordinated bonds are not covered by any deposit guarantee scheme. The investor is exposed to the risk that Erste Group Bank AG may not be able to meet its obligations arising from the bond in the event of insolvency or over-indebtedness or from an official order (bail-in regime). Due to the subordinated nature of the obligations of Erste Group Bank AG from the bond, in the event of insolvency of Erste Group Bank AG the claims of the creditors from the bond are only served when all claims of non-subordinated creditors of Erste Group Bank AG have been fulfilled. The claims of the creditors from the bond cannot be offset against the claims of Erste Group Bank AG. A total loss of invested capital is possible.

How do subordinated bonds react to…

… rising interest rates?
Subordinated bonds with fixed interest rate fall when interest rates are rising. If you sell this bond prior to maturity, you may record a loss.
Subordinated bonds with floating interest rate, on the other hand, benefit from rising interest rates. Given that these bonds ("floaters") have their interest rate periodically adjusted to a referential rate such as the EURIBOR, an increase in the level of interest rates also means a rising interest rate for the bond. The price of the bond tends to oscillate around face value.

… stable interest rates?
In the case of stable interest rates, neither the price nor the coupon of the subordinated bond changes (if other criteria, e.g. the rating of the issuer, stays unchanged).

… falling interest rates?
Subordinated bonds with fixed interest rate increase when interest rates are falling. If you sell this bond prior to maturity, you may record a profit.
Falling interest rates, on the other hand, have a negative impact on subordinated bonds with floating interest rate. Given that these bonds ("floaters") have their interest rate periodically adjusted to a referential rate such as the EURIBOR, a decrease in the level of interest rates also means a falling interest rate for the bond. The price of the bond tends to oscillate around face value.

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