By Jonathan Jackson, CFA, FRM, Manager of Brokerage Services
At the beginning of 2022, the NCUA instituted the Subordinated Debt Regulation which replaced the Secondary Capital Rule. This regulation permits credit unions to issue subordinated debt as a way to boost their capital position. As more credit unions look to issue subordinated debt, you are likely to see opportunities to invest in these credit union-issued subordinated debt notes.
Is investing in subordinated debt right for your credit union? There are few important considerations when analyzing subordinated debt investment opportunities.
The standard structure of a credit union-issued subordinated debt note is a fixed-rate coupon with a final maturity of 10 years. The notes are issued as private placement securities, and most will not have a CUSIP number or be rated. Notes are available to cover losses before deposit insurance payouts and will be uninsured and unsecured. Most subordinated debt issuers will pay off the notes at a pace of 20% per year in years six through 10, which results in an average life on the investment of 7½ years.
The reason for this prepayment, or call, is due to the regulatory net worth treatment rules. In the final five years of the maturity term, by rule, the issuing credit union must reduce the amount counted towards net worth by 20% annually, down to zero at the maturity date. Every deal can be different, so review each investment opportunity carefully.
As an investor in subordinated debt, you have access to the following benefits for your credit union:
- +175-400 basis point spread over benchmark U.S. Treasuries
- Predictable cash flows – no extension or contraction risk
- Balance sheet diversification
- Long-term, high-yield asset to ride out volatile rate cycles
- An opportunity to support growth for fellow credit unions
With those benefits, risks are expected, such as:
- Interest rate risk created by 7½-year average life
- Limited secondary market liquidity – the notes will have a wide bid/ask spread
- Regulatory 12.5x risk-based capital factor for credit unions that do not opt for the Complex Credit Union Leverage Ratio (CCULR)
- Credit risk with an unsecured and subordinated instrument
Examining and reviewing the credit risk of the issuer will be key when analyzing potential credit union-issued subordinated debt investments. When determining whether to invest in an issuer, credit unions are encouraged to evaluate multiple key areas. These areas include, but are not limited to, growth trends, earnings capacity, liquidity position, loan quality, risk exposure, issuance use cases and planned use of funds.
Ultimately, you want to look for a growing credit union with stable loan quality, strong liquidity management, reasonable risk parameters and a healthy net worth.
Comfortable with those risks? Consider this set of additional criteria to see if your credit union is a suitable investor for subordinated debt:
- No outstanding subordinated debt or secondary capital issuances
- Must have accredited investor status (most credit unions do)
- Have established written policies
- Have board approval prior to investment
- Is well capitalized
- Maximum investment amounts the lessor of:
- 25 percent of net worth
- Dollar amount of net worth above 7%
If you’ve checked the boxes, Catalyst Corporate’s brokerage team is here to help with questions and policy language to position your credit union for success. For more information, contact us today.
All securities are offered through CU Investment Solutions, LLC. The home office is located at 8500 W 110th St, Suite 650, Overland Park, KS 66210. CU Investment Solutions, LLC registered with the Securities and Exchange Commission (SEC) as a broker-dealer under the Securities Exchange Act of 1934. CU Investment Solutions, LLC is registered in the state of Kansas as an investment advisor. Member of FINRA and SIPC. All investments carry risk; please speak with your representative to gain a full understanding of said risks. Securities offered are not insured by the FDIC or NCUSIF and may lose value. All opinions, prices and yields are subject to change without notice.