Generally, we believe that the spread difference between Lower Tier 2 and Tier 1 bonds of the same issuer should primarily reflect the maturity –
or rather call date – extension associated with switching out of a Lower Tier 2 into a Tier 1 bond of the same issuer, and the risk premium required
to move down the capital structure. As a proxy for the risk premium we use the implied equity volatility of the bank’s common stock. A switch from a Lower Tier 2 to Tier 1 may involve issues with different maturity and call dates, respectively. Hence, the subordination premium should be greater between securities of different tenors. Since investors are usually more comfortable holding Tier 1 debt of highly rated banks which normally have a stable equity base, the subordination premiums tend to vary by the issuer’s rating and the issuer’s implied equity volatility. Typically, the more highly rated an institution, the lower one would expect the subordination premium to be, and vice versa. This relative value analysis is therefore most effective for comparisons of similarly rated banks.
