Tuesday 21 March 2017 by John Manning Education (advanced)

Non preferred senior bonds – a new class of bonds for Australian investors

Australia looks set to introduce a new class of bond – non preferred senior. We look at what non preferred senior is, whether it’s the new Tier 3 many investors have been waiting for and what the implications are for the Australian bond market

unwrapping a present

Following BNP Paribas’ first Australian non preferred senior bond issue last week, we look at what non preferred senior actually means, whether or not this is the new Tier 3 many investors have been waiting for and what the implications are for the Australian bond market, which is dominated by senior unsecured bank bonds.

These bonds have loss absorption clauses, making them subordinate to senior bonds in the capital structure. Given higher risk, they offer higher yields over senior debt but importantly contribute to regulatory capital. The market is in its infancy but overseas issuance has seen a pick up in yield of 50bps to 60bps above senior unsecured debt.

In my view, the eventual introduction of non-preferred senior bonds in Australia, as the prime measure by which the domestically systemically important banks could meet their total loss absorbing capacity (TLAC) requirements, is highly probable. While the banks could raise additional capital, by issuing new equity, cutting dividends or increasing issuance of subordinated debt or hybrids, we think it would be insufficient to satisfy expected TLAC levels in the time required. This could reshape the domestic bond market and create new opportunities for a pickup in yield.

Background

As globally systemically important banks (G-SIBs) look to build their TLAC eligible debt levels under the Basel III reform agenda, different corporate structures across global banking markets are changing how various jurisdictions are looking to meet their requirements under TLAC. For banks with holding company structures, such as the UK and Switzerland, TLAC compliance is not an issue as senior bonds issued out of the holding company – and not the operating company – are structurally subordinate, bail in instruments. However, across continental Europe and Australia, holding company structures are not prevalent.

Issued at the operating company level, TLAC eligible debt must contain either statutory or contractual bail in clauses. Statutory – legislated in Germany to apply to its banks – legislates that all existing senior unsecured debt is now considered non preferred or subordinate to other senior unsecured creditors, and subject to bail in provisions. Cognisant of the Australian banking system’s heavy reliance on global wholesale funding markets, and senior bank debt dominates the domestic market, introducing statutory bail in within Australia is widely regarded as not being viable alternative as shown in Figure 1.

Total non government bonds on issue – all currency denominations

Figure 1
*Australian dollar denominated bonds only
Source: ABS, RBA

In contrast, contractual bail in has been approved in France and effectively introduces a new class of bonds for both issuers and investors called non preferred senior. Where holding company structures are not available, the European Commission has recommended continental Europe should adopt this structure. This is best shown in Figure 2.

TLAC and depositor protection in European operating companies


Figure 2
Source: CreditSights, FIIG Securities
*DGS: Deposit guarantee scheme
** >seven days to maturity
^Point of non viability

Non preferred senior is not Tier 3

Non preferred senior does not gain formal regulatory capital recognition and can only be bailed in under a formal resolution process. Further, it is not subject to point of non-viability triggers by local regulators. As these are clearly debt instruments non preferred instruments should prove attractive to investors that do not have the appetite to participate in the structurally complex, Basel III compliant Additional Tier 1 and Tier 2 market.  

Astute investors willing to accept the structural complexity of Tier 2 subordinated debt will unlikely be attracted by the lower yields of non-preferred instruments. However, more conservative investors who prefer to play in the senior unsecured debt range could find the additional returns on offer compelling. While the non preferred segment is in its infancy, initial pricing on these instruments has offered 50bps to 60bps above senior unsecured debt, whilst being at the lower end of holding company senior debt.

Where to in Australia?

Australia’s banking regulator APRA, announced early 2016 it was working on TLAC and how it might be applied to the domestically systematic important banks (D-SIB) - ANZ, CBA, NAB and Westpac. Whilst APRA has been quiet on this matter for some time, the structural nuances of the domestic market infer that a non preferred senior route could offer:

  1. Stability in the domestic market, where existing senior unsecured investors are not structurally subordinated – unlike investors in German banks.
  2. Opportunity for investors via a new class of bonds, offering higher yields whilst preserving seniority to subordinated debt.
  3. A consistent approach to global regulation implementing TLAC controls for D-SIBs.

On balance we would not expect APRA to implement any TLAC reforms that would be effective prior to 1 January 2018. However, we would expect a draft ruling to be released to the market mid 2017 for industry consultation, allowing time for any banks subject to TLAC in Australia to issue sufficient paper in an orderly manner.

Ultimately, the introduction of a new class of bond of bonds in non preferred senior bond would likely have a major impact on the shape of the domestic bond market. Initially, it could reduce the senior unsecured funding requirement of the four majors – driving a technical squeeze on those bonds – while opening up new investment opportunities for investors who target a well-diversified business profile and seek additional spread.


Glossary

APRA

APRA is charged with the prudential supervision of Authorised Deposit-taking Institutions (ADIs). Its ultimate aim is to ensure financial promises made by the bodies it regulates are met within a stable, efficient and competitive financial market. It oversees, banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies and most members of the superannuation industry.

Basel III

Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector.

Basis points

The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed income security. The relationship between percentage changes and basis points can be summarised as:



D-SIB

Domestically systematically important bank (D-SIB)

G-SIB

Globally systematically important bank (G-SIB) – none of the Australian banks are on this list.

A financial institution whose distress or disorderly failure, because of its size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.

Holding company

A company that owns other companies’ outstanding stock. Usually, the company does not produce goods or services itself; rather, its purpose is to own shares of other companies to form a corporate group.

Non preferred senior

A new class of debt that is explicitly senior, however the terms and conditions of the bonds highlight that it will sit above Tier 2 but below other senior liabilities in the creditor hierarchy stack.

Operating company

The company that is the actual manufacturer or a product or service.

Point of non viability

Point of non viability, the point at which regulators decide a bank is no longer able to function. To count towards regulatory capital ratios under Basel III, subordinated bonds must be written down to zero or converted to equity when the trigger is hit.

Subordinated debt

A bond or loan that ranks below senior debt, loans and creditors. In the event of a wind up (insolvency) of an issuer, subordinated debt is not paid until all senior debt and unsecured creditors are paid first.

Total loss absorbing capacity (TLAC)

The debt or capital available to absorb losses in banks.

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