As published in The Australian on 27 May 2017
Global credit rating agency Standard and Poor’s this week downgraded the credit ratings of 23 Australian financial institutions by one rating notch. The downgrades sent prices marginally lower and yields up on a range of investments, providing a welcome window of better returns in a tight market
Most of the downgrades applied to regional banks such as AMP, Bank of Queensland, Bendigo and Adelaide Bank, Credit Union Australia and ME Bank.
Controversially, the big four banks – ANZ, CBA, NAB and Westpac were excluded from the downgrade. But bank hybrids – which are popular with many investors – did not escape.
Ratings for the four majors remained at AA- with a negative outlook, supported by the expectation of likely financial support by the Commonwealth government, according to the S&P report.
However, S&P downgraded both the subordinated debt and hybrid ratings as, in its view, the government would be unlikely to support those securities.
This is an important point. A global institution that measures perceived risk is suggesting these securities are increasing in risk.
Investors should take note and reassess current portfolio allocations and returns – are you comfortable with the risk in bank hybrids and that you are being paid enough for it?
Or looking at the bigger picture, do you have enough diversity in your investments across asset classes, sectors, companies and geographic locations?
Theoretically the cost to issue new subordinated debt and hybrids for the majors just increased with the change in credit ratings. We would usually expect to see some downward pressure in prices for existing securities when this happens, however the high numbers of retail investors looking for income means hybrids may well continue to find support.
The stated reason for the wider downgrade was that economic imbalances were growing in S&P’s view due to a rapid rise in private sector debt and house prices, particularly in Sydney and Melbourne. The agency said “a rapid rise in property prices or strong growth in private sector debt generally signals a higher risk that a sharp correction in property prices could occur”. In that instance, credit losses would be significantly higher, weakening the institutions.
The outlooks for the regional banks were stable except Auswide and MyState which remain on negative as S&P considered weakening capital ratios may lead to a further one notch downgrade. Further, Auswide’s credit rating is now on CreditWatch with negative implications.
Credit ratings can be complex. If we take a major bank as an example, it will have an issuer credit rating which is usually the same rating that is applied to its senior unsecured bonds but is potentially different for covered bonds, subordinated bonds and hybrids reflecting the risks of those various investments.
Issuer credit ratings are typically lower for subordinated bonds and then lower again for hybrids, not something most retail investors are aware of. Deposits, aside benefiting from a $250,000 Commonwealth government guarantee, usually mirror the issuer credit rating.
Importantly, credit ratings are used to help investors determine the probability of default, they are not applied to ordinary shares, as shares never make any formal commitment to pay dividends or return capital.
Practically, major bank and insurance company bonds, as well as offshore bonds were largely unaffected. Regional banks’ senior and subordinated bonds priced a little cheaper, especially those crossing from investment grade to non investment grade.
For example an ME Bank subordinated bond moved from the lowest investment grade credit rating to non investment grade and the price dropped roughly 50 cents to circa $101.50, having little impact on the overall return.
RMBS issuer, Liberty Financial, announced a new corporate bond issue. Liberty’s Issuer credit rating was originally BBB (with a negative outlook) but at launch Liberty was one of the 23 institutions downgraded and suffered a one notch downgrading to BBB-(stable). Fortunately Liberty’s corporate bond issuance terms include a covenant including a step up in yield if the institution was downgraded, and subsequently the yield increased by 0.50 per cent – a good result for those that bid on the new deal.
We expect regional banks will need to increase deposit rates to attract funds, particularly to satisfy institutional investors that invest large sums exceeding the $250,000 deposit guarantee. Foreign banks, unaffected by the credit rating downgrades may drop deposit rates.
We are yet to see any movement in deposit rates with banks typically adjusting rates on a weekly basis.
Note: At FIIG we do not trade in listed hybrid securities as we consider they are not fixed income and do not provide the protections offered by bonds and other fixed income securities.