Due to client demand we have added bank Tier 1 securities and deeply discounted bank subordinated paper (‘discos’) to our offering. In addition to broadening our product suite, we hope this will provide price discovery and transparency to clients.
This document has been prepared by FIIG Investment Strategy Group. Opinions expressed may differ from those of FIIG Credit Research.
In the current investment environment of heightened volatility and low returns, investors are seeking higher risk investments to support their income objectives. While Tier 1 capital securities and discos are considered riskier than higher ranking bonds issued by the same bank, they are also less risky compared to other high-yielding investment options.
Banks issue Tier 1 capital securities such as hybrids to satisfy their overall capital requirements set by the local banking regulator, APRA. Issuance of these securities also allows a bank to diversify their funding sources, which also include equity, senior bonds and subordinated bonds (Tier 2 capital).
Bank equity and retained earnings form what is known as CET1 capital, this is the strongest and most loss absorbent form of capital, followed by Additional Tier 1 capital and then Tier 2 capital. The purpose of Tier 1 securities is to be able to absorb losses to protect more senior ranking creditors such as Tier 2 securities, senior bank bonds and depositors.
It is worth noting that since the implementation of the Basel III accord the nature of Tier 1 securities has changed. The main point to note is that discos are pre-Basel III Upper Tier 2 subordinated notes that still currently contribute toward an issuer’s regulatory capital, although on an amortising basis under APRA’s Basel III implementation transitional arrangements. However, the positive contribution to regulatory capital from discos ends in January 2022 with many investors believing that this will trigger the issuer to call these securities prior at a higher price than the current trading price.
Tier 1 securities and discos have differing security characteristics to bonds issued by a bank. These are summarised in the table below:
1: Tier 1 securities issued in Australia will generally include a date-based mandatory equity conversion but similar instruments issued in the US or Europe will not incorporate such features.
Source: FIIG Securities
Currently we have four new securities available in our offering. Two of these are Tier 1 hybrids while the other two are pre-Basel III issued securities, or discos as they have been referred to above. Each individual security offers a slightly different rationale for investment.
The key factor to note with these securities is the credit quality of the issuers of all of these securities. They are all issued by strongly regulated and well capitalised Australian financial institutions. Furthermore, S&P has very recently updated its ratings assessment of the banks, with the Tier 1 securities being upgraded to investment grade ratings, similar to Moody’s and Fitch.
Tier 1 securities trade at a higher margin than equivalent rated Tier 2 sub-debt or senior bank bonds due to the hybrid nature of these securities. Fox example, the recently issued NABPF Tier 1 security has a margin of 3mBBSW + 2.92%, whereas a NAB senior bond and Tier 2 sub-debt with similar maturity trade at a margin of 0.47% and 1.82%, respectively. The higher coupon on Tier 1 securities, combined with their fully franked coupon make them an attractive investment for those investors who can tolerate higher risk.
As the name suggests, the discos trade well below par and are suitable for investors who have a strong opinion on the likelihood of these being called at par (or repurchased at a premium to current trading price) once their regulatory capital qualification changes in 2022. In the recent past two European issuers have called their discos at prices above where these securities were trading. Similarly, the NAB disco has been trading in the USD85-USD90 range since 2017 (after trading as low as USD55 in the previous five years), when NAB commenced an on-market buy-back program, indicating its intention to gradually redeem this security.
It is also worth highlighting that these securities are traded in the OTC market and FIIG can improve price discovery and transparency for clients who wish to trade these securities. We have noted other market participants providing access to these securities, in particular the discos, at prices not reflective of the market levels.
The chart below will be familiar to many investors as it highlights the performance of Tier 1 securities during the last major crisis. What is evident here is the influence the price of a bank’s share price has on the performance of the Tier 1 security.While Tier 1 securities provide high income potential they offer investors low, if any, capital protection in times of stress. During 2008-2009, when there was strong market uncertainty, hybrid prices were highly correlated with equity prices (red circle), and when markets settled down and equities rebounded, hybrid prices were correlated with bond prices (green circle).
Source: FIIG Securities, Bloomberg
A more recent example of how equity price impacts the price of Tier 1 securities can be observed through the price movement of various securities issued by AMP. AMP’s share price experienced significant volatility following the Royal Commission into banking. The Tier 1 security issued by AMP also experienced price volatility but to a much lesser extent with prices remaining broadly above par, whereas the price of the AMP Tier 2 sub-debt remained close to par for the whole period. The chart below shows this price movement (indexed) since Nov-2018, which was when the Tier 2 sub-debt was issued.
Source: FIIG Securities, Bloomberg
It is relatively difficult to compare value in these securities, different as they are to more easily comparable bonds with defined maturity dates. A number of assumptions must be made, which can be absolutely critical to the estimated return of the securities, such as the assumption of a call at a particular date.
The key determinant of the yield on these two particular securities is the call date to which pricing is calculated as they trade at a significant discount to par, and if called are likely to be redeemed at par. Hence, the earlier the call, the higher the yield.
These securities offer a running yield (annual income) comparable to existing Tier 2 subordinated bonds (recognising they are denominated in USD and equivalent subordinated bonds are generally denominated in AUD) from the same issuers, but with the significant uncertainty of the call date occurring as anticipated.
Our view is that currently these securities are priced as if they are not likely to be called in the near future, although it does remain a possibility, as we have seen other similar securities from European banks called at par recently from similar market levels.
As such, investors may need to be prepared for having to sell these securities on the open market to recover their capital if a call does not eventuate, at a time when market pricing may not be favourable.
The chart below compares the yield to various call dates against the running yield:
Source: Bloomberg, FIIG Securities
Post Basel III Hybrids
The majority of Hybrids in Australia are listed on the ASX. The number traded in the OTC market is small and in our opinion not likely to get materially larger in the short term. As such we have focused on the USD denominated versions where we can add value to clients through price discovery and transparency.
It is unsurprising that given the similarity of the issuers and the securities themselves, hybrids issued by Australian major banks trade at very similar levels based on the expected call date.
Importantly, as with the discos, it is the expectation of this call date which will drive returns. Australian major banks have exercised their first call at every opportunity to date, and there is no expectation that this will not continue to be the case. However, APRA has informally noted that they expect calls to be executed for economic reasons and not purely for reputational, as was the case in the past.
It is therefore important to look at the implications if a call is missed, to determine the economic outcome for the issuer post the missed call.
Of the two securities we are contemplating, the ANZ looks to have a superior likelihood of call as the reset margin if not called is the prevailing 5 year swap rate + 5.168%, as compared to the 5 year swap rate + 2.888% for the Westpac.
Each individual fixed income investor has varying risk tolerance. We believe given the fact that Tier 1 securities and discos carry higher risk than a bond issued by the same entity, these securities are better suited for investors with a higher risk threshold.
The risk of capital loss through default is estimated to be about the same as equivalently rated investment grade bonds, and as such, given we make those securities available, it has been decided to add these other income producing securities to our offering.
The market price risk of these securities is a separate consideration. In stressed market conditions, we would expect to see high downward price volatility as has been observed above. The risk of extension due to a non-call is also present, as there are no defined final legal maturities (with cash repayments) such as can be found in genuine subordinated bonds.
It is worth highlighting that we continue to be very selective when it comes to deciding which particular securities we offer for sale to clients.
In summary, we believe it is important to offer clients a wide range of choice when accessing securities with a fixed income style of payment designed to solve the problem of generating income in a low-yielding environment. The robust methodology by which FIIG selects securities to be made available, and the following pricing transparency and ease of market access, has led us to this decision as a result of enquiry from clients.
Please contact your relationship manager if you have interest in these securities.
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