There has been strong demand for the $7.1 billion issuance of Australian bank Basel 3 compliant ASX listed hybrid bonds. We believe the returns offered by these new structures are not fully reflecting their risks.
Senior Portfolio Manager
Are popular new hybrid bonds good value – or not?
Institutional fixed income investors have recently been concerned with pricing the new terms in Australia’s banking sector Basel 3 compliant Tier 1 (T1) and Tier 2 (T2) instruments.
The recent new style T1 and T2 deals have attracted significant retail investor demand, which has allowed the banks to access a cheap source of capital funding relative to what they would be expected to pay if they were to issue into the wholesale market. One reason for this is the differential in the extra spread margin that retail and institutional investors require for the non-viability as well as equity conversion features.
We believe that recent ASX listed hybrid deals have not adequately priced the risk of non-viability and consequently, there are opportunities in the market which offer greater returns for less risk. We contend that ‘old style’ major bank offshore wholesale T1 deals offer better value.
What is non-viability?
The key issue with non-viability is that APRA (the Australian Prudential Regulatory Authority) has kept its definition vague. There is no clear market consensus on what it is and the multitude of scenarios that could trigger a non-viability event.
Non-viability is often regarded as the point immediately before an event of default. This is defined in terms of the bank’s capital ratio deteriorating to a critically low level that it is unable to continue as a going concern. APRA has set the equity conversion common equity T1 capital trigger ratio to be 5.125% for recent deals, which is frequently regarded as a yard stick for non-viability.
However, recent bank failures globally have occurred not due to a lack of capital in reported numbers, but due to liquidity, capital or funding markets freezing up for a bank due to a removal of confidence. The most recent example came in the Netherlands with SNS Reaal being nationalised due to high commercial property impairments, refinancing concerns and its inability to find private investors to inject capital into the business. It’s most recent published Core T1 Capital ratio was 8.8% as at Q3 2012.
Separately, at 31 May 2008 Lehman Brothers reported a T1 Capital Ratio of 10.7% and a total risk based capital ratio of 16.1%. These ratios were materially above the 5.125% trigger level, which indicates that other liquidity and funding risks can be key drivers of a non-viability event.
This suggests that non-viability cannot be defined purely in terms of a capital ratio and that a broad range of key credit metrics must be analysed and monitored. Forward-looking analysis is also an important element of risk management as there are significant downside risks for hybrid investors if an issuer’s credit fundamentals deteriorate. Once problems arise it is quite possible that the secondary market liquidity for the banks new capital instruments would be poor.
What happens if non-viability is triggered?
Upon the occurrence of a capital or non-viability trigger event, the regulator will determine the amount of capital required by the regulator to be injected into a bank. In such a case, a waterfall structure would apply to new style T1 and T2 holders in terms of conversion to equity. However given the major banks are approximately 16x levered then it is conceivable that both T1 and T2 holders (new style only) would be subject to a full conversion to equity in a tail event stress scenario. At this point T2 holders would be exchanged into equity at the same conversion rate as T1 holders. So while T2 is generally expected to be priced tighter than T1, the losses would be similar at a point of non-viability.
These losses can be significant. For example, assuming a 90% fall in the share price and full conversion to equity, losses of 50% of invested capital would be expected for new style T1 and T2 holders. This is because an equity conversion due to a capital trigger or non-viability event is calculated on a Volume weighted average price (VWAP) set at 20% of the issue date VWAP.
While there is little probability that this risk will be realised, the risk must still be priced. Investors that participate in AUD T2 transactions need to assess whether they are adequately compensated for that risk.
The vague regulatory definition around non-viability exposes investors to a broad range of liquidity, capital and regulatory risks. We believe that it is not possible to definitively calculate how much non-viability is worth in extra spread terms because it has equity and debt like components. However some methods are:
Calculate the probability of non-viability and the loss given non-viability
Attempt to isolate the equity conversion risks at a point of non-viability using similar instruments issued offshore
Value it as a series of long dated puts.
The table below lists a number of deals across old style and new style T1 and T2. As we employ a global framework for our credit research, we have also included USD deals.
The extra spread required for non-viability is not priced into the ASX listed market and this is seen when comparing new style T1 in Australia relative to old style T1. There is no major bank new style T2 for comparative purposes, but we have included the Suncorp new style T2 deal.
In summary, for shorter duration and better terms we can add an extra +144bps yield to call (YTC) over AUD new style T1 hybrids (CBA PERLS 6) by investing in USD old Style T1 (CBA 6.024%). Offshore old style T2 (WSTP 3.625%) offers an extra 81bps over ASX-listed old style T2 (WSTP 2.75%) on a YTC basis. Westpac 3.625% USD old style T2 trades flat to the recent Suncorp new style T2 deal despite Westpac having a stronger credit profile. These comparisons show how the ASX listed market is not adequately pricing for non-viability risk.
In the event of non-viability, old style notes effectively rank ahead of new style instruments, assuming there is no event of default or legislative application of the non-viability language to old style T1 and T2 instruments.
Importance of research
Old style T1 and T2 instruments form part of our portfolios and offer an attractive risk return profile relative to new style deals. We have not participated in the recent AUD bank hybrid deals as they are not adequately pricing in the uncertainty and risks surrounding non-viability.
In order to manage the risks associated with highly subordinated instruments, real time understanding of a bank’s fundamentals and the terms of the instrument are imperative. The downside risks in these new style instruments are significantly greater at a point of non-viability.
We see old style T1 as a source of alpha generation through stock selection and a component of our diversified portfolio.
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