Realizing the Opportunity in the Subordinated Debt Market
CUs looking to drive balance sheet growth, merge or boost regulatory capital levels can benefit from exploring this market.
The NCUA’s low-income designation program offers a number of regulatory benefits for eligible credit unions and the members they serve, including the authority to obtain supplemental capital. As the number of low-income designated credit unions (LICUs) has grown and the NCUA’s Final Rule on Subordinated Debt has taken effect expanding issuer eligibility, there is more opportunity than ever before for the industry to realize the potential benefits of the subordinated debt market.
What Is Subordinated Debt?
Subordinated debt is an unsecured loan and is treated as regulatory capital due to its subordination to all other creditors. Additionally, subordinated debt is considered another “layer of protection” subordinate to NCUSIF. As shown below, subordinated debt is uninsured and included in statutory net worth for LICUs only. Subordinated debt issued by a non-LICU will not be included in net worth or the net worth ratio. Regardless of designation, all credit unions that qualify to issue subordinated debt can include subordinated debt in their risk-based capital (RBC) ratio.
Regulatory Net Worth
How Is Subordinated Debt Structured?
Over the years, the broader subordinated debt market has grown and evolved. A total of $33.8 billion was issued from 2014 through mid-2021, with a significant spike in issuance in 2020. The most common structure, which accounts for approximately 95% of this volume, is 10-year non-call 5’s (10NC5). Its features include:
- 10-year maturity with par call after five years, fixed-to-floating coupon
- Fixed for first five years, flips to floating last five years if not called
NCUA regulations require that credit union-issued subordinated debt be at least five years, but no greater than 20 years, in maturity. Additionally, subordinated debt cannot be repaid prior to five years from the date of issuance. Once subordinated debt ages to within five years of stated maturity, its regulatory capital value diminishes by 20% each year, as shown in the table below.
Regulatory Capital Weighting
Why Issue Subordinated Debt?
Eligible credit unions may choose to issue subordinated debt for a number of reasons, including to:
1. Expand products/services and lending
2. Support growth
- Organic
- Branch purchases
- Mergers & acquisitions
3. Diversify sources of capital
- Increase statutory capital
As credit unions evaluate their unique use case, it is important to understand that subordinated debt is not perpetual capital. When building a strategic plan for deploying subordinated debt, the institution should ensure that the application of subordinated debt can sufficiently cover the debt’s carrying cost, additional leverage expense and repayment timelines.
How to Prepare to Issue Subordinated Debt
The NCUA’s new rule on subordinated debt became effective Jan. 1, 2022, although LICUs could issue previously. In addition to developing a clear use case including detailed strategy to deploy subordinated debt, institutions interested in becoming issuers must take time to adequately prepare for internal and external audiences. Part of this process includes preparing investor presentations, which typically include detailed information such as the following:
- Offering term sheet
- Management biographies
- Balance sheet and income statement highlights
- Proforma financials and strategic plan
Whether an eligible credit union is looking to drive balance sheet growth, merge or boost regulatory capital levels, the opportunity in the subordinated debt market is worth consideration as part of a forward-thinking cooperative’s long-term strategy. Partnering with an experienced investment professional and balance sheet strategy consultant to thoroughly evaluate your options is a solid starting point in the subordinated debt, or any, market.
Brittany Rollek is Managing Director of Client Experience for the Dallas-based ALM First Financial Advisors.